The Art of Drafting Milestones for an Earn-Out

Former stockholders of SARcode Bioscience were recently denied a claim that they were entitled to be paid $425 million in milestone payments under a merger agreement. The decision provides an anecdotal lesson in drafting milestones and suggests that the more technically prescribed milestones may be more difficult to meet, even though the development of the drug is ultimately successful.

In Fortis Advisors v. Shire, the Delaware Court of Chancery granted Shire’s motion to dismiss a complaint filed by the stockholder representative of the former stockholders of SARcode Bioscience seeking the payment of two milestones totaling $425 million. The first milestone related to the outcome of a Phase 2 clinical trial of the drug in development to treat dry eye disease. It required the occurrence of an “achievement date,” which the merger agreement defined as the receipt of audited final tables, figures and listings from an OPUS-2 Study demonstrating that both components of the co-primary efficacy endpoints of the study, as specified in an attached OPUS-2 Study Protocol, was achieved. The definition also required that a specified safety standard (not relevant to the dispute) was also achieved. At the time of the acquisition, the Phase 2 clinical trial was ongoing. The second milestone was payable upon receipt of regulatory approval for the drug, contingent on the occurrence of the achievement date milestone.

The drug did not meet the co-primary endpoints in the OPUS-2 Study with statistical significance, but Shire elected to proceed with development of the drug. Shire subsequently conducted a Phase 3 trial and submitted a New Drug Approval application that included data from the OPUS-2 study, the Phase 3 trial and other studies. Ultimately, the drug received regulatory approval. Fortis, as representative of the former stockholders, sought payment of the two milestones and argued that the merger agreement should be interpreted as allowing consideration of clinical data from prior clinical trials, not just the OPUS-2 study, in determining whether the co-primary endpoints had been achieved for purposes of determining whether the “achievement date” had occurred. The drug had achieved the primary endpoints in earlier studies. Shire argued that the merger agreement should be interpreted as allowing only consideration of data from the OPUS-2 study to determine whether the co-primary endpoints were met.

The court agreed with Shire, ruling that Shire offered the only reasonable interpretation of the plain language in the merger agreement. The court held that since the “achievement date” was defined by reference to the outcome of a specific study as set forth in an attached protocol, the first milestone was clearly not achieved because both of the co-primary endpoints in the referenced OPUS-2 study were not met with statistical significance. The court further found that since the second regulatory approval milestone was premised on the occurrence of the “achievement date,” which was not met, the regulatory approval milestone was also not earned.

The court based its findings on a plain reading of the merger agreement. It rejected the sellers’ arguments that the milestone did not expressly exclude consideration of other studies and therefore the results of other clinical studies could be included, noting that the merger agreement specifically referenced the OPUS-2 study, and did not reference the results of other clinical studies. It further rejected an argument that the results simply needed to be achieved, or realized, and did not need to be achieved in a statistically significant manner, noting that the milestone included an attached protocol that required the results to be achieved in a statistically significant manner.

Earn-outs can provide a helpful tool to bridge a valuation gap between parties and are a typical component (SRS: 64%) of acquisitions of development-stage life sciences companies where parties often share the risks and rewards of clinical and regulatory development through contingent milestone payments. In life sciences deals, earn-outs can comprise a significant percentage of the total deal consideration in a sale.

Buyers often propose milestones based on the successful outcome of clinical trials and sellers often seek greater definition of what a successful outcome of a clinical trial means. In this case, while we do not know the history of the parties’ negotiation, it appears that the parties bargained for a narrow definition of a successful outcome of the pending clinical trial and the outcome of the trial did not meet this technical definition. When buyers decide to continue to invest in the development of a drug despite the drug not succeeding in a clinical trial, from the buyer’s perspective, the buyer is taking a risk at considerable expense. In this case, the buyer may have made this investment decision, in part, believing that it would not be obligated to make any additional milestone payments if the drug were successfully developed. A well-advised seller may try to protect itself from the risk of a clinical study not meeting an endpoint in a statistically significant manner even though its development remains viable by requesting during the negotiations a backstop where the milestone would also be deemed satisfied if the buyer elected to advance the drug to a later phase of development.

Drafting milestones is a highly fact-specific exercise based on many factors. As we noted in a previous post, particularly as milestones relate to clinical development and regulatory approvals, it is important that the technical description of the milestone comports with the parties’ broader business expectations. From a seller’s perspective, defining success based on technical failure of the drug by reference to a particular clinical trial may be too narrow and result in an adverse outcome for the seller even if the drug is ultimately successful from a regulatory perspective and therefore successful from a business standpoint. A seller would be well advised to consult closely with all relevant business, legal and technical experts and to consider alternative measures of success. As this decision makes clear, a court will not blue-pencil the milestones or look beyond the plain words of the contract if there is no ambiguity.

See a copy of Fortis Advisors LLC v. Shire US Holdings, Inc. (C.A. No. 12147-VCS, August 9, 2017).