Milestone Payments: Potential Trouble In The Last Mile?
By Brian Koosed, Emily Seiderman West, and Stephanie Diu
Earnouts have been a part of M&A for decades, with pharmaceutical M&A transactions in particular relying on them. These earnout provisions are typically referred to as “milestone payments” because they are tied to the achievement of certain “milestones” in the drug development process, such as successful clinical trials or regulatory approvals. And they almost universally depend on one thing: a predictable regulatory approval process from the FDA, on a fairly predictable timeline. Indeed, some of the FDA’s timing is required by law; for example, under 21 C.F.R. § 314.100, FDA must, with certain exceptions, review and respond to generic drug applications (ANDAs) within 180 days.
This raises the question: what happens when these timelines — based on industry assumptions, if not also explicit rules and regulations, that the FDA will work at a certain cadence on a particular kind of drug application — are no longer predictable? Unfortunately, these questions now appear to be a growing reality for pharmaceutical companies, given recent proposed changes to FDA staffing levels initiated by the Trump administration. This article explores the implications of those proposed changes on pharmaceutical M&A transactions, offering practical guidance for parties who are either in the midst of negotiating such a transaction, or facing uncertainty about whether an existing milestone provision can still be achieved within the time frame originally envisioned when the deal was signed.
Pharmaceutical M&A Milestone Provisions
It’s a common problem in M&A: how do you value something that may not even work, and whose market is unknown? Earnouts bridge that valuation gap. And they are especially prevalent in the pharmaceutical industry, where many drug companies are acquired before knowing whether they have a viable, marketable drug. In fact, a recent report from M&A financial services company SRS Acquiom found that in a study of 383 life sciences deals, 272 involved an earnout provision. In this way, tying earnout payments to specific milestones in the drug development process — i.e., milestone payments — makes perfect sense, aligning the economic interests of both buyers and sellers by triggering additional payments when certain drug development milestones are met.
Because these development milestones themselves depend on the FDA’s drug approval processes and specific regulatory pathways, the typical timelines for successfully navigating those processes and pathways are often incorporated by reference into an M&A contract’s milestone provisions, including a contractually defined “drop dead date” for achieving each milestone.
Simultaneously, to keep buyers honest, merger agreements typically impose obligations on the buyer to actively work toward achieving the milestones. These often come in the form of “commercially reasonable efforts” (CRE) clauses, which typically define the buyer’s obligation in one of two ways: (i) outward-facing, looking to an industry standard as a yardstick, which is generally seller-friendly; or (ii) inward-facing, applying the buyer’s own diligence standards, which is usually buyer-friendly since the buyer can compare its past practices to the buyer’s present efforts on the drug at issue.
Courts are no stranger to milestone disputes that often turn on precisely how the seller’s CRE obligations were defined in the applicable M&A contract. For example, in 3DT Holdings LLC v. Bard Access Systems Inc., 3DT sold its catheter navigation technology, Penske, to Bard under an agreement requiring Bard to use CRE to develop a product incorporating Penske. 2022 WL 2951593 (S.D.N.Y. June 24, 2022). The CRE clause gave Bard significant discretion, stating that what constituted CRE would be “determined by Bard, in good faith, based upon its reasonable business judgment.” After three years, if Bard in good faith found the product commercially impracticable, it would not owe further milestone payments.
When Bard ultimately ceased development, 3DT sued for breach of contract. After a bench trial, the court ruled for Bard, finding that Bard had discretion under the CRE clause and acted within the bounds of that discretion. To be sure, regulatory delays — caused in part by unexpected FDA guidance — slowed the Penske project’s development. But the court noted that the Penske project remained active throughout the delay, with ongoing testing and design updates. In short, because the parties’ CRE clause granted Bard meaningful decision-making leeway, when exercised in good faith, Bard was protected from contractual liability even when the FDA process threw Bard curveballs that resulted in significant delays.
In Fortis Advisors LLC v. Johnson & Johnson, by contrast, Johnson & Johnson bought 3D surgical robot technology for $3.4 billion, with an additional $2.35 billion contingent on achieving certain milestones related to regulatory clearance. 2024 WL 4048060 (Del. Ch. Sept. 4, 2024). However, J&J’s efforts to secure FDA approval for the robot technology were hindered by a change in FDA policy regarding the 510(k) clearance process. The plaintiff argued that J&J violated the CRE clause by destroying the robots’ chances of achieving clearance, while J&J contended that the milestones were no longer achievable after the FDA’s regulatory shift.
The Delaware Chancery Court found in the plaintiff’s favor on some grounds, and in J&J’s favor on others. In finding that J&J failed to use CRE to achieve certain of the contractual milestones, the Court relied heavily on the specific CRE clause in the parties’ contract, which defined CRE as the efforts consistent with the company’s “usual practice” for “priority medical device products of similar commercial potential at a similar stage in the product life cycle,” considering factors such as likelihood and difficulty of obtaining regulatory approval. Even though the FDA changed the parties’ contemplated pathway for regulatory approval (510(k) clearance) post-closing and midway through the development process, the Court determined that this change in FDA policy did not automatically excuse J&J from its obligations to use CRE to achieve the milestones. Instead, J&J was still required to pursue an alternative regulatory pathway once 510(k) clearance was no longer an option.
As these cases and others make clear, how the CRE obligation is defined in relation to the FDA’s approval processes may have an outsize role on whether milestone payments are ultimately owed. And, as the J&J case shows, building in contingencies for changes in FDA procedures, and acknowledging that regulatory timelines may take longer than expected, may end up being dispositive. These kinds of considerations take on even more importance in the current regulatory environment, where, as discussed below, failure to meet contractual deadlines for achieving future milestones may end up being as much a function of the FDA’s actions as the buyer’s.
The Current Regulatory Environment: Anticipating A Slower FDA
In the last few months, the Trump administration, through its newly established Department of Government Efficiency (DOGE), has terminated thousands of employees at federal health agencies. The FDA is slowing down as a result, including missing statutory deadlines because of its staffing shortages. The slowdown is likely to persist at least for a few more months; under a related executive order, President Trump’s administration has imposed a hiring freeze on federal agencies until July 15, 2025, and even after the hiring freeze lifts, agencies can only add one new employee for every four who’ve left.
Taken together, these policies could limit the FDA’s ability to process drug applications, hold meetings with sponsors, and maintain the pace of drug approvals. Pharmaceutical companies have noticed. Several recently filed 10-Ks include statements identifying FDA delays — specifically those stemming from the Trump Administration’s recent policy changes — as material risks to their operations, drug development timelines, and potential commercial milestones. For example, one biopharmaceutical company recently reported in its Form 10-K filed with the SEC that:
Recent actions by the Trump Administration have renewed concerns that disruptions will adversely affect executive branch functions . . . .
Reports indicate that 5,000 out of 80,000 [Department of Health and Human Services] employees have been terminated, including FDA employees. Although we cannot be certain at this early stage, these terminations, if they withstand legal challenges, may significantly delay and impede our interactions with FDA. . . . There are also reports that the Trump Administration intends to request Congress to reduce FDA funding in upcoming budgets. Such funding cuts may also delay the development and approval of our products. . . .
If funding shortages, staffing reductions or changes, a prolonged government shutdown or slowdown or other disruptions occur, the ability of the FDA and other regulatory authorities to timely review and process regulatory submissions could be significantly impacted, which could have a material adverse effect on our business.(Emphasis added).
These and other recent pharmaceutical SEC filings underscore how seriously the industry is taking this issue and may serve as early warnings to dealmakers.
Where Do We Go From Here?
For those currently party to a contract with milestone provisions, or those negotiating one, these regulatory developments — and the likelihood of a slower-moving FDA going forward — need to be top of mind. Here are a few key takeaways to consider depending on whether you are already party to a contract with milestone provisions, or are currently negotiating one:
Existing Milestone Provisions: If you’ve already signed and closed on a sale or acquisition, the cake has obviously been baked in terms of the milestone provisions themselves. But look at your M&A contract’s definition of CRE (or comparable obligations). Do they take into account regulatory developments, government funding cuts, etc.? If so, they may provide a basis for leveraging those obligations to push the buyer to take the FDA’s staffing cuts into account. Working with counsel may also help leverage these kinds of provisions to your benefit.
Separately, if your M&A contract’s milestone provisions contain “drop dead dates” for the achievement of certain milestones, consider your relationship with the buyer. Are you a pharma or biotech VC firm and have a counter-party with whom you regularly do deals? If there is a long-standing relationship, it may be worth exploring whether an amendment of the existing “drop dead dates” is viable in light of recent FDA staffing developments. If not, counsel may be able to assist you in identifying other contract provisions in your deal documents that nevertheless may require the buyer to take the FDA’s staffing issues into account for purposes of achieving the milestones and satisfying the buyer’s CRE obligations.
Negotiating Milestone Provisions: The takeaway for those currently negotiating milestone provisions is more straightforward: push your counter-party to agree to CRE obligations, and “drop dead dates,” that explicitly reference and reflect the FDA’s new reality, including that the FDA’s statutory deadlines may nevertheless be missed due to a lack of staffing, a lack of funding, or both. Building in more time to achieve each milestone is thus paramount. If nothing else, this also will allow you to create a record that the issue was top of mind during the negotiation process, something that courts may well examine to determine what the parties intended in the event of a future milestone dispute. For example, in Shareholder Representatives LLC v. Alexion Pharmaceuticals, Inc., the Delaware Chancery Court focused on the parties’ merger negotiations, including scientific and legal input provided to draft the milestone provisions, in finding that the buyer was liable to the seller for a $130 million earnout payment. 2024 WL 4052343 (Del. Ch. Sept. 5, 2024).
All told, adapting to the new regulatory reality may complicate M&A for pharma buyers and sellers alike. Proactively approaching these issues, and working with counsel when helpful, is one way to protect yourself, whether you already have milestone deals in place, or are currently negotiating them.
About The Authors:
Brian D. Koosed is a partner in the Washington, D.C. and New York offices of Venable LLP. A seasoned litigator, Brian represents corporations, financial institutions, and high-net-worth individuals in all aspects of commercial litigation and arbitration, including in “milestone” and other pre- and post-closing disputes arising out of complex M&A transactions, particularly in the context of “business divorces.”
Emily Seiderman West is counsel in the New York City office of Venable LLP. She focuses her practice on complex commercial litigation and government investigations. She has experience representing clients in federal and state courts, as well as in arbitration proceedings.
Stephanie P. Diu is an associate in the New York City office of Venable LLP. She works on teams representing clients in commercial litigation matters.