This blog covers a Delaware Court of Chancery case involving a $1 billion earnout dispute over FDA milestones in the acquisition of a surgical robotics startup. The post highlights key legal issues such as earnout provisions, commercially reasonable efforts obligations, breaches of good faith, and fraud in the context of mergers and acquisitions. It also explores the complex dynamics between regulatory approvals and competing products in high-stakes M&A deals within the medical device industry.
M&A Stories
September 23, 2024
Earnouts are a common feature in M&A, especially when the acquired business deals with innovative medical devices requiring regulatory approval. However, they often lead to post-closing litigation, as seen in a recent Delaware Court of Chancery case.
This case involved the 2019 acquisition of a venture-backed robotic surgery startup by a global multi-billion-dollar company. The startup had developed two breakthrough surgical robots: one specialized in diagnosing and treating lung cancer, and another that advanced abdominal surgeries like gallbladder removal and hernia repairs. While the startup was making significant progress, the buyer, whose own surgical robot development was lagging, saw the acquisition as a strategic opportunity to enter the competitive surgical robotics market.
The deal closed with a $3.4 billion upfront payment and an additional earnout of up to $2.35 billion based on FDA regulatory milestones, primarily tied to the second surgical robot. To address concerns that the buyer might prioritize its own competing robot over the acquired technology, the merger agreement required the buyer to use “commercially reasonable efforts” to achieve FDA approval for the acquired robots, treating them as a priority medical device.
When the milestones weren’t met, the seller sued, claiming that the buyer had failed to meet its obligations. The court agreed, awarding the seller $1 billion in damages.
The buyer breached its efforts obligation in two key ways. First, it delayed work on FDA milestones by forcing the startup to compete in a “bakeoff” against the buyer’s own surgical robot, resulting in significant delays. Although the startup’s robot ultimately won, the distraction set back regulatory progress. Second, the buyer merged its own surgical robot team with the startup’s, which led to a breakdown in teamwork and the loss of key personnel.
The court also found that the buyer breached the implied covenant of good faith and fair dealing. After the acquisition, the FDA shifted the approval process for the startup’s robot to a more complex pathway, requiring clinical data due to its novel design. The buyer, instead of supporting this new approval process, chose to abandon the earnout, arguing that the milestones were tied to the easier pathway, which was no longer available.
Lastly, the court held the buyer accountable for fraud, as it had failed to disclose before closing that a key component the buyer was to supply for the startup’s robot had been delayed due to a patient death in clinical trials.
Despite the significant damages awarded, the seller was unable to recover its legal fees due to the absence of a fee-shifting provision in the merger agreement. Given the length of the court’s decision, it’s likely those fees were substantial.
This case underscores the risks of earnouts tied to regulatory milestones, especially when the buyer has a competing product. The seller had tried to mitigate this risk by requiring the buyer to treat the acquired robot as a priority medical device, but the buyer’s lack of support for the more difficult FDA pathway ultimately led to a costly legal battle.
Case Reference: Fortis Advisors LLC v. Johnson & Johnson., C.A. No. 2020-0881-LWW , Court of Chancery of Delaware, (September 4, 2024).
Thank you for reading this blog. If you have any questions, insights, or if you’d like to engage in a more detailed discussion on this matter, I invite you to reach out directly.
Feel free to send me an email. I value thoughtful discussions and am always open to connecting with business owners, management, as well as professionals who share an interest in the complexities of M&A law.
By John McCauley: I write about recenegal problems of buyers and sellers of small businesses.
Email: jmccauley@mk-law.com
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