Marriott Harrison LLP
London, United Kingdom
The decision in Porton Capital Technology Funds and others v 3M UK Holdings Limited and another 2011] EWHC 2895 (Comm)) demonstrates how having an earn out as part of the purchase price calculation can go wrong.
US multinational 3M offered to acquire Acolyte, the target business, for an initial price of £10.4 million, as it believed that Acolyte’s new product for dealing with the MRSA superbug, “BacLite”, had great commercial potential worldwide.
The deal also included an earn out which potentially would provide the sellers with further consideration equal to 100 per cent. of the revenue from worldwide sales of BacLite during 2009, up to a maximum of £41 million.
The sale agreement included terms that 3M would:
3M, for its part, insisted on a provision stating that it was not obliged to operate its business in a manner that increased the earn out payments.
However, after completion, matters did not go to plan. In brief, over the course of the rest of 2007 and 2008, against a background of very substantial expenditure in connection to the product by 3M, the market for BacLite began to disappear. By the end of March 2008, testing and approval for a launch in the US and Canada had been put on hold.
3M then approached the sellers for consent to shut down Acolyte in exchange for a payment of just over $1 million. The sellers however demanded the maximum earn out payment of £41 million in exchange for their consent.
3M argued that this refusal meant that the sellers were unreasonably withholding their consent, in breach of the sale agreement. The sellers however countered that 3M was in breach of the agreement because it had neither “actively marketed”, nor “diligently” sought the relevant regulatory approvals for, BacLite.
At trial, the High Court concluded that:
With regards to the withholding of consent, it was for 3M to prove unreasonableness, for example, that because of some ulterior motive, and not, for example, because the sellers had not weighed up 3M’s costs against their interests in the earn out.
In the absence of any sale agreement, it would have been a reasonable commercial decision for 3M to close down the business. However, the Court held that was a different issue to whether or not it was unreasonable for the sellers to withhold consent to the closure. The Court then awarded, based on its best estimate of what the actual sales of BacLite would have been, just over $2 million to the Sellers, more than double 3M’s original offer, but well short of the maximum possible earn out.
The decision highlights the uncertainties of an earn out. When negotiating the sale agreement, it is important to bear in mind what the underlying sales or other financial projections are, and what might happen to the market and the business during the earn out interval. The buyer does not want to be locked in to, or pay in respect of, an obviously struggling business.
Separately, the case also illustrates that while “consent not to be unreasonably withheld” is a legal and commercial solution often applied to allow issues to be settled during a transaction, it is an approach which could potentially pose problems in the future. At the very least, the parties should consider if there are any specific circumstances in which consent either cannot be refused or is deemed to be given.