This article originally appeared in Life Science Leader on July 1, 2022.
As has now become an annual tradition, when the calendar turned to 2022, several commentators — including Freshfields, in our Life Sciences: What To Expect in 2022 report — shared predictions for what we would see in the life sciences industry in the coming year.
From these predictions, a few common forecasts emerged — namely, an anticipated rebound in life sciences M&A activity and the continued prevalence of licensing and collaboration deals in the space. Given the challenges that the IPO market has faced this year, and with biotech valuations continuing to languish after a precipitous drop in the second half of 2021 and into 2022, we continue to expect deal activity, especially M&A in the biopharma space, to pick up. Accordingly, now is an opportune time to take a fresh look at some key considerations regarding a common feature of these types of transactions — payments that become due in the future upon the achievement of specified events, which are commonly known as “milestones” (or, as they are known in public M&A deals, “contingent value rights” or “CVRs”).
Milestones are ubiquitous in both life sciences M&A and licensing and collaboration deals, used both as a tool to bridge valuation gaps and also in recognition of the fact that each hurdle cleared in the development of a drug or therapy can significantly increase the value of the product by reducing the risk that it will fail prior to approval. While milestones can be a useful dealmaking construct, negotiators should keep in mind they can lead to disputes if not structured carefully.
The best way to reduce the risk of disputes is to define milestones so they are conditioned to objective events that the parties reasonably expect to be achieved as part of the anticipated development plan or commercialization strategy for the specific product. For example, milestones are often structured to be payable upon the initiation of a clinical trial, the regulatory approval of a product, the achievement of a minimum level of sales for the product, or other clear-cut achievements that signal value creation and/or de-risking of the asset. Subjectively defined milestones, such as those requiring the “successful completion” of a clinical trial, as well as terms of art, should generally be avoided. When structuring milestone payments, another point to consider is whether payment should be conditioned on achievement of the triggering event by a certain date. While these types of deadlines have certain appeal, particularly for buyers and licensees, they also can raise the risk of disputes if the milestone is not achieved, as the record will be examined for any evidence that the buyer or licensee dragged their feet in an attempt to avoid making payment.
Another set of challenges arises from the use of “diligence” clauses, which are routinely agreed to in connection with milestones. Life sciences is an unpredictable industry — the successful development and commercialization of a product depends on several factors that are not entirely within the control of the performing party. Rather than creating an absolute obligation for the buyer or licensee to achieve a specific milestone, diligence clauses acknowledge this inherent unpredictability and, instead, require a party to use a certain level of efforts to perform specified activities and/or achieve defined objectives. Sellers and licensors typically want buyers and licensees bound by diligence obligations to ensure they devote sufficient efforts to the acquired or licensed assets, with the objective of increasing the chances they receive milestone payments. In some cases, licensors — most often universities and other academic institutions — will require that the licensee agrees to achieve certain milestones by specified dates. Conversely, buyers and licensees often resist these obligations — especially diligence obligations required to be met by specific deadlines — arguing that they are already incentivized to expend appropriate efforts (particularly if the transaction involves a large up-front payment), as well as arguing that the obligations reduce the flexibility they need to address issues as they arise.
The level of efforts that a party must use is often highly negotiated. While many jurisdictions have case law purporting to interpret what is meant by common phrases such as “best efforts” and “commercially reasonable efforts,” it is typical to contractually define the level of efforts that must be used to achieve the relevant objectives for the specific asset. Courts will then apply the agreed standard (often styled as “commercially reasonable efforts” in the U.S.) to the relevant facts — rather than relying on old, and often inconsistent, case law to navigate a path. Typically, commercially reasonable efforts definitions compare the level of efforts (i.e., resources and investment) that a party is obligated to expend to either the level of efforts that party usually expends for similar products in similar circumstances (a so-called “internal” or “subjective” standard) or, alternatively, to such efforts that a similarly situated company would use in such circumstances (an “industry” or “objective” standard).
To monitor compliance with diligence and milestone payment obligations, sellers and licensors typically negotiate for information rights, such as regular reports from the buyer or licensee or the ability to meet with the buyer’s or licensee’s management team to understand how the program is progressing. Buyers and licensees attempt to limit the breadth of these rights, arguing they interfere with their operations and can be used as a pretext for sellers and licensors to build their cases for related disputes. In the licensing context, especially if the transaction involves a research or development collaboration, there also will frequently be joint committees that serve as forums for information sharing and decision-making.
When a party fails to achieve a milestone — or slows, reduces, or ceases its efforts to achieve it — it is common for disputes to arise as to whether the party complied with its relevant diligence obligations. While these types of disputes are frequently resolved outside formal proceedings, it is not uncommon to see such disputes result in litigation or arbitration. These proceedings typically involve delving into the details of efforts that were made toward the relevant program in terms of financial expenditures, personnel, and other resources. Accordingly, such proceedings can end up becoming extensive investigations as to what was done, when, by whom, and why — meaning these disputes, and their outcomes, are highly fact-specific and therefore unpredictable.
Thus, the risk of disputes should always be front of mind when considering deploying milestones in these transactions. It bears noting that such disputes tend to be more common in M&A transactions than in licensing and collaboration deals. A recent SRS Acquiom study found that, from 2008 to 2019, milestone-related disputes arose in over 30% of private life sciences M&A transactions structured using milestones. This differential between licensing and collaboration and M&A transactions can be traced to a number of sources. Unlike in licensing and collaboration deals, where the licensor often collaborates with the licensee post-closing, including through its participation on governance committees, M&A sellers are generally not involved and have limited visibility as to the conduct of the acquired programs post-closing. This raises the level of distrust if the program appears to be lagging. Another factor is that, with licensing and collaboration deals, licensees frequently have the right to terminate the agreement and return the asset to the licensor, which is a right that is not seen in M&A deals. Often, such a “hand-back” of the program is the preferred path for a licensee rather than simply shuttering a program and risking a potential argument over whether doing so breached the agreement.
While the use of milestones in life sciences M&A and licensing transactions will, no doubt, continue to be pervasive, negotiators should approach them carefully given the long-term ramifications and potential for disputes.