New Life Science Earnout Study Details The Richness of Post-Acquisition “Gravy”

Escrow service Shareholder Representative Services, which oversees a good portion of earnout-based deals, has published exclusive data that show, among other things, that one-third of post-acquisition milestones are paying out.

With biopharma venture investors these days likely to sell their portfolio companies in a structured acquisition, it’s safe to say we’ve entered the age of earnouts. And now, a firm involved in dozens of such deals in the past four years has released the first formal study to shed light on how those earnouts are paying out – or not.

Shareholder Representative Services LLC has found a large market in recent years for its escrow services in the life science field, now dominated by acquisitions in which the selling shareholders receive only partial payment at the close of the deal. The rest comes in the months or years to follow as key products progress in the hands of the buyers. SRS oversees the distribution of funds as post-acquisition payments are triggered by clinical, regulatory or sales milestones.

The SRS study, released Sept. 12, encompasses 47 deals from mid-2008 through the first half of 2012. It’s a fraction of the earnout based deals overall in the industry, but observers agree it’s a significant sample size because of SRS’ access to all documents and data in the deals it oversees. The data were presented strictly in aggregate. “It captures what a lot of deal practitioners believe anecdotally is happening,” says Kingsley Taft, co-chair of the life science practice at Boston-based law firm Goodwin Procter. “It makes the process of selling a company in this earnout-driven world more consistent.”

SRS counted 47 acquisitions of either biopharma or medical device companies, 39 of which included earnouts that totaled $7 billion in potential payments, or 43% of total deal value. Upfront payments totaled $8.6 billion, or 53% of total deal value. (The rest is or was held in escrow; equity investments and uncapped royalties were not included in the total deal value.) In SRS’s deal set, in other words, sellers are capturing more than half the deal totals at signing, consistent with other published estimates, including an analysis of the earnout trend in our sister publication START-UP earlier this year. (See (Also see "For Biotech VCs, Anticipation And Adjustments In The Age Of Earn-Outs" - Scrip, 26 Mar, 2012.).)

More important, however, are the returns those upfront payments represent, and how much extra the earnouts can add. The average return in the set was slightly more than 3x, with a wide range from zero to 16x.

But beyond the “steak” of those upfront returns, says SRS executive director Donald Morrissey, investors shouldn’t expect a lot of near-term “gravy” from the earnouts. In the SRS deal set, a majority of milestones timed to come to fruition within two years of deal close would boost returns by 1.5x or less. But Morrissey cautions that these particular data are strictly best-case scenarios; they don’t factor in the probability of products failing or milestones being delayed.

To get a better sense of the risk factors, SRS tallied all milestones and the dates on which the sellers projected or contracts stipulated they would be hit. Overall, 36% that have reached their projected trigger date have in fact been triggered and paid out; 28% have been delayed; and 36% have been missed. In dollar terms, those three groups represent 30%, 40%, and 30% of aggregate dollars.

“Now that these data sets are becoming robust, I continue to be intrigued by the fact that one-third of milestones are being paid,” says Atlas Venture partner Bruce Booth, who has tracked and written about earnouts on his popular blog LifeSciVC.com. “That’s quite a lot of money.”

Those data take on a different flavor when the “delayed” milestones are split between those that sellers expect to hit and those they expect to miss. Reconfigured, the data set looks like this: 52% of milestones come due have either paid or should pay; 48% have missed or are likely to miss.

Another way to slice the milestones is by their projected trigger dates. Those expected to come due in the first year after deal close have in fact paid out only a fraction, about $175 million of a potential nearly $1.2 billion.

As the first aggregate data set to show how many earnouts are actually paying out, it could encourage a secondary market for those rights, especially as more venture funds come to the end of their charters and need to cash in on unrealized holdings. “Only several hundred million of the $7 billion in earnouts have been paid,” says Morrissey. “There’s still a lot of money sitting out there for continuing programs.”

One recent example of secondary demand came in May, when Royalty Pharma bought the earnout rights held by shareholders of Fumapharm AG that would come due as Biogen Inc. advances the multiple sclerosis drug BG-12. (See (Also see "Deals Of The Week: Sandoz/Fougera, Abbott/Action Pharma/Zealand, AstraZeneca/Axerion" - Pink Sheet, 7 May, 2012.).) Biogen bought Fumapharm in 2006 for $215 million and undisclosed earnouts [See Deal]. Royalty Pharma is paying $761 million to the Fumapharm shareholders to take possession of the earnout rights.

Current funds might be hamstrung with the need to clear long-term earnouts from their books. But one VC points to new biotech business models, which to date are still more experiments than anything, and says firms successful enough to raise new funds might start to structure companies in ways that let them keep those earnout-based assets on their books longer. “If you get a nice multiple return on the upfront, and 10 years later there’s something really great that can happen, as long as that can flow through efficiently to the limited partners, they don’t care,” says CMEA Capital managing director Karl Handelsman. “There will be groups like SRS to monitor and make sure funds get distributed in an efficient way. It’s good for both LPs and entrepreneurs if there’s another nice slug of money that can change people’s lives.”

Quick Facts From the SRS Earnout Study

• Between mid-2008 and the first half of 2012, the firm oversaw 39 deals with earnouts encompassing 206 separate milestones.
• 53% of the $16.3 billion in total deal value was paid upfront ($8.6 billion) and 43% is represented by earnouts ($7 billion).
• Of the milestones that have reached a trigger date, 36% have paid out, 28% have been delayed, and 36% have been missed.