When a deal value deferred by milestones is still a good deal

By Larry Haimovitch

Medical Device Daily Columnist

March 6, 2011

Recently, I received a call from a reporter asking for my reactions to the announcement that Boston Scientific (BSC; Natick Massachusetts) was acquiring privately held, venture capital-backed Atritech (Plymouth, Minnesota) for $100 million in cash upfront with potential milestone or earnout payments that could total an additional $275 million (Medical Device Daily, Jan. 20, 2011).

Atritech has been the pioneer in the fledgling field of left atrial appendage (LAA) closure, with its Watchman device, which is designed to close the LAA in patients with atrial fibrillation. The Watchman will likely be the first LAA closure device implanted percutaneously to enter the U.S. market although an FDA approval is not a shoo-in. Indeed, despite meeting the primary endpoints in its PROTECT-AF 800-patient randomized pivotal trial with a 38% relative risk reduction for stroke, cardiovascular death and systemic embolism compared to long-term warfarin therapy and a positive FDA advisory panel recommendation, in March 2010 the FDA issued a "non-approval" letter and asked the company to do an additional confirmatory trial. Atritech is now enrolling patients in a follow-up study called PREVAIL. The Watchman has a CE mark and is currently being sold in Europe.

After I finished the interview, I reflected on the conversation and asked myself this question: what determines how an earnout is structured?

There are myriad factors that help determine how any deal is negotiated and specifically what an earnout might look like. Earnouts are used almost exclusively when a private company is acquired but only rarely when a public company is bought.

A recent example of a public company transaction with an earnout is the proposed acquisition of Genzyme (Cambridge, Massachusetts) by Sanofi-Aventis (Paris), where the latter is issuing a tradeable security called a "contingent value right" (CVR) as a means to "sweeten the pot." Essentially, If Genzyme's business reaches certain milestones after the deal, Genzyme shareholders will get additional payments.

Most of the med-tech deals that have been consummated in recent years have occurred when a larger publicly-traded device company has bought an earlier stage private company. These are typically cash deals, some with a full 100% of the purchase price paid in cash upon closing, others with some initial cash upfront and an earnout that is typically based on regulatory approvals and/or the achievement of revenue targets.

While generalizations are dangerous, it is fair to say that the cash upfront is reduced when there is less perceived risk, whether it be product development, clinical or regulatory. Conversely, more cash is disbursed upfront when the perceived risk is lower. However, and this is a big however, if a company is deemed to be very attractive and there is a bidding process, the value of a deal can be increased with most or all of the cash paid immediately.

Okay, so, let's look at a couple of examples. In October 2009, Abbott (Abbott PArk, Illinois) acquired privately-owned, VC-backed Visiogen (Irvine, California) for a reported $400 million in cash, all upfront. In fact, the true deal value was closer to $425 million, as Visiogen shareholders were able to collect the cash that they had invested several months earlier. At the time of the acquisition, Visogen had already filed a PMA application for its accomodating intraocular lens (A-IOL) Synchrony, which has demonstrated excellent results in numerous clinical trials. A-IOL sales have been growing rapidly in recent years and this was a category where Abbott lagged notably vs. its key competitors.

This $425 million price tag, all up front, was a surprisingly large amount considering that there was still significant regulatory risk for Abbott. As it has turned out, the PMA that Visiogen filed in the summer of 2009 has yet to be approved. Indeed, it looks like an FDA approval is still many months away as the FDA continues to pepper Abbott with a litany of questions. Approval will undoubtedly require an FDA Ophthalmic Devices Panel (OPD) meeting and at this point, there is no OPD meeting scheduled for the rest of 2011.

So, why did Abbott pay $425 million for a company without an FDA approval? My industry sources indicate that another large strategic buyer was keenly interested in buying Visiogen and that Abbott decided to make a very generous offer to insure that they would be the eventual buyer.

So, the combination of intense competitive bidding, an attractive market opportunity and an excellent product allowed Visiogen to sell at an outstanding price with 100% cash upfront.

Conversely, the Atritech transaction, which was valued at a total of $375 million, had a modest 27% of the cash paid upfront. Interestingly, the $100 million initial payment was just a few million dollars more than the total amount of VC capital that has been invested in the company to date. The thinking of management and the VCs was likely: "let me get my cash invested out and hope that we will achieve the milestones, in which case it will turn out to be a very good investment."

From Boston Scientific's perspective, it has limited its investment risk to $100 million while acquiring the leading player in the percutaneous LAA closure space. If the Watchman gains full FDA approval, which I think is more than likely, BSC will have the first FDA-cleared product in a market that some industry pundits think could be worth several hundred million dollars annually. BSC would happily pay the full earnout if FDA clearance is attained.

An earnout deal that I happened to be invested in as an angel investor was privately-owned, VC-backed InSound Medical (Newark, California) a developer of a very innovative, invisible, extended wear hearing device called Lyric. In January 2010, publicly-traded Sonova Holding (Stafa, Switzerland) bought InSound with an initial cash payment of $75 million, which not so coincidentally was equal to the invested capital put into InSound since its inception. In addition, Sonova committed to future potential earn-out payments which they estimated would be in the range of $175 to $275 million.

In a surprising turn of events, ten days ago Sonova announced a change in the existing acquisition agreement with a one-off payment of $94 million replacing the existing complex earn-out agreement. This effectively released both Sonova and the former owners of InSound from all mutual obligations.

There has been no explanation why the companies decided to go in this direction but both parties seem quite pleased. For InSound shareholders, this is a welcome development as just 18 months earlier, the company was struggling to raise money and was facing a very dilutive VC round of funding. Now, they will have received a total of $171 million from Sonova, an attractive selling price considering that it had estimated revenue in 2010 of about $12 million.

Sonova also seems very pleased, as evidenced by the comment from its CEO Valentin Chapero, who said that "this agreement will enable us to develop our business with Lyric in an optimal way . . . Sonova is now enabled to focus its entire distribution organization on the commercial potential of Lyric in the U.S."

So, it looks like both parties are happy, which is ideally how every deal should end. In my next column, I will discuss a few other earnout deals, the majority of which of have not had as pleasant an ending.

Editors Note: Larry Haimovitch, founder of Haimovitch Medical Technology Consultants (Mill Valley, California), can be reached at Larryhaim@aol.com. His opinions do not necessarily reflect those of Medical Device Daily editors.

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