DELAWARE COURT REJECTS MEDICAL DEVICE SELLERS’ EARNOUT CLAIM

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The Delaware Court of Chancery holds that the buyer of the medical device used “good faith” and “commercially best efforts” to commercialize the sellers’ medical device.

M&A Stories

September 29, 2022

Introduction

Deals involving the acquisition of an unproven medical device are often structured to include a significant earnout potential.

The deal

This deal involved the purchase of a start-up company that was developing a clip applier product to be used in minimally invasive surgeries. The parties allocated the risk associated with the continued development of the clip applier through a contingent payment structure. The buyer agreed to pay the sellers $1.25 million up front, to make milestone payments of up to a total $10.25 million upon the product’s achievement of four development objectives, and to make earn-out payments of $2 million upon the first sale and in the amount of 10% of the net sales generated for five years after the first sale.

Because the bulk of consideration to be paid to the sellers was contingent on the clip applier achieving development milestones and financial targets after the buyer acquired the company, the sellers obtained the buyer’s agreement to use commercially best efforts to maximize the milestone and earn-out payments. The sellers further negotiated for the right to demand accelerated payment of the milestone and earn-out payments if the buyer permanently discontinued the development or sale of the clip applier products unless that determination was made for contractually specified reasons, including that the clip applier posed a risk of injury to patients.

Before the parties entered into the stock purchase agreement, the buyer identified safety issues in the clip appliers’ design. As part of the stock purchase agreement, the buyer negotiated for the right to implement design changes to address those concerns. Those design changes were identified in a schedule to the agreement. After the parties closed on the agreement, the buyer invested approximately $10 million and nearly 15,000 engineering hours into implementing those design changes and developing the clip applier in other ways. The buyer put the product through multiple animal lab studies and applied for and obtained FDA clearance. By October 2015, the buyer had made the up-front payment and three of the four milestone payments, for a total of $9 million in payments to sellers.

The buyer, however, continued to encounter problems in the product’s development, including safety features identified in the schedule to the stock purchase agreement. In early 2016, the buyer tasked a newly acquired and highly experienced development team with reevaluating the product. They concluded that the buyer should scrap the product entirely in favor of developing a new clip applier. In May 2016, the buyer notified the sellers of the buyer’s view that the clip applier posed a risk of injury to patients and that the buyer was seriously questioning whether to move forward with development of the product. Shortly after the report, the buyer’s board determined to discontinue development of the product.

In response to the report, the sellers demanded acceleration payments. The buyer declined to make the payments, and the sellers sued.

The lawsuit

The court held for the buyer, concluding after trial that the buyer had acted in good faith and used commercially best efforts to commercialize the device and also discontinued development after determining that the device “posed a risk of injury to patients.”

See Menn v. Conmed Corporation And Endodynamix, Inc., C.A. No. 2017-0137-KSJM, Court of Chancery of Delaware, (Submitted: March 14, 2022, June 30, 2022).

 Comment 

The sellers had a very weak position. The buyer’s conduct gave the seller a reasonable chance of receiving the full earnout.

By John McCauley: I write about recent legal problems of buyer and sellers of small businesses.

Email:             jmccauley@mk-law.com

Profile:            http://www.martindale.com/John-B-McCauley/176725-lawyer.htm

Telephone:      714 273-6291

Check out my book: Buying Assets of a Small Business: Problems Taken From Recent Legal Battles 

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