Earnout deals are back in the news with an interesting report from Shareholder Representative Services, or SRS, a firm who specializes in working for the selling party’s shareholders to follow up post-acquisition to ensure that escrows are paid, diligence is done, and milestones are tracked. They are increasingly relevant and important as more earnout-based deals get done.
SRS has assembled an intriguing dataset of Life Science deals which offers insight into the metrics around M&A-related earnouts, especially as a comparison to an older dataset I’ve posted about in the past (here). This data involves 47 undisclosed private-target pharma and medtech deals, including 39 with earnout payments (representing some 200+ discrete milestones). These include nearly $9B upfront payments and $7B in potential milestones. All the deals in this set are rather young, having closed from 3Q 2008-2Q 2012, with a bias towards more recent closings (in line with the growth of SRS’ business). It’s a dataset that broadly mirrors the sector’s value distribution: 27% of deals had upfronts worth $250M or more, which is in line with other statistics for deals of this valuation range (here).
Although many of these aren’t new insights, here are some of the key observations gleaned from the data:
- LS deals have much higher frequency of earnouts than other sectors SRS tracks: 83% vs 15% of M&A deals. This isn’t “new news” given the well discussed trend toward risk-sharing deals in LS, but the quantification of the stark contrast to other sectors is still eye-opening.
- Unsurprising to readers of this blog, the capital invested doesn’t correlate with bigger exit returns; in fact the 7 largest deals on an upfront multiple basis all raised a below average amount of equity capital vs the rest of the dataset (<$60M). Further, the range in upfront return multiples is huge and renders averages useless: deals went from 0.1x up to 16x upfront.
- LS investors and boards are far more generous with regard to vesting for their employees at deal closing than boards in others sectors. Boards voted to fully accelerate the vesting of options for 82% of LS deals vs only 24% in other sectors. I’m not sure why this is the case; one speculation is that the more generous acceleration practice may be a reflection of the fact that most tech entrepreneurs have far higher equity ownership to begin with (here).
- Biopharma deals were faster to exit than the Medtech deals in this dataset: median of 6.5 years vs 8.0 years. Unclear whether the Medtech future milestones are of shorter or longer duration than the BioPharma payments.
- Post-acquisition diligence requirements vary across the board, but the majority of development-stage milestones require only the “commercially reasonable efforts” standard. Further, only 8% of deals managed to craft language around clawing back a program if the buyer didn’t advance it. I know this gets complicated, but it’s a shame not to see more of this given portfolio shuffling that goes on in Pharma (where good assets can die through neglect).
- Lastly, the achievement and payout of near-term milestones is reasonably high to date. In this rather young dataset, only 25 milestones had come “due” in SRS’s assessment. Of those, 36% were met and paid (reflecting 30% of the dollars in this subset), and another 16% were delayed but likely to be paid. About third had missed, and the remainder were delayed and unlikely to be met. This distribution implies that nearly 50% of near-term milestones have or are likely to be paid. SRS also quantifies the value of near term milestones; it appears that roughly 50% of milestone values are within the first four years, and for most deals they can add another 2-3x multiple with those near term milestones. Since upfronts are often in the 2x range, this additional return in the near term payments can propel a deal into a top decile outcome (>5x is top decile for any venture deal, regardless of sector).
Earlier this year, this blog (here) and Alex Lash at Startup (here) published on earnouts with a more mature set of seals (Jan 2005-Dec 2009 deals in this blog’s set), and concluded that 25% of milestone values had already been paid out. While those analyses are a different cut and sample set than SRS’ data (which looks only at milestones that should have been met by now), the SRS findings in the last bullet above are reasonably consistent with our prior findings that a meaningful percentage of milestones are getting paid.
Now that more of these earnout deals are maturing, it will be interesting to see how SRS’ database evolves; it’s likely to become one of the best data-rich sources of this milestone payment information.
Two further comments more generally about milestones and implications for our sector:
- VC firms need to figure out how to standardize the accounting of these earnout payments in our LP reporting. Since a reasonable percentage of the early milestones are statistically likely to pay out, these can reflect a significant amount of value. In the past, most firms reported the future value as zero, which clearly undervalues them. We now build expected value models based on industry attrition rates and the time value of money, and include the parent value of the future payments on our books. It’s never very much, but it’s only appropriate to determine the fair value of these financial instruments. At Avila, we’ve valued the future earnouts at 10% of their nominal value – which is about a full 1x on the deal. Its clear that venture firms are all over the map here in how they do this; I think our industry and sector needs to set some standards for these approaches.
- It’s only a matter of time before dedicated biotech milestone-buying funds get raised to monetize these payment streams, especially since defined earnouts have a certain probability of being met and can be modeled off both attrition data and historic patterns. Royalty funds emerged after the R&D vehicles of the 80s and 90s created a lot of royalty streams; there are now a bunch of these funds buying actual and synthetic royalties. With ~$12B+ in earnouts floating out there in deals since 2005, there’s plenty of substrate for new dedicated funds to try to monetize. The pressure to create a market for these financial instruments is only going to increase as the 10-12 year venture fund life approaches with significant milestones remaining out in the future. If not new dedicated funds, it seems to me that secondary funds which buyout a venture find’s stakes may be in a good position to pick these future streams up.
Milestones aren’t going away any time soon, and are likely to contribute in a meaningful way to the returns of our sector over the next decade. Thanks to SRS for sharing this useful data, and look forward to updates over time. As an industry, we’re going to need to build the right processes, standards, and markets for taking these future milestones into consideration.