Deal Structure in Medtech M&A Considerations, Part 1

This column is the first of a two-part series on deferred consideration in medtech M&A. The good news about deferred consideration is that it’s a great way to close a potential valuation gap between buyer and seller. These valuation gaps often occur when the seller wants the buyer to pay for the forward growth of the salable company, and the buyer only wants to pay for the firm’s current value. It’s not an unreasonable discussion but the way it is handled is critical to all stakeholders. 

Many medtech M&A deals do not require deferred compensation. When the topic does appear, however, it deserves the same scrutiny—if not greater—as the headline price.

Deal structure scrutiny in our M&A practice has proven that found deferred compensation (when it occurs) can be a productive value enhancer for both parties in medtech M&A transactions. But a troubling trend seems to be occurring in medical technology earnouts: Contingent consideration now appears in 84% of private medical device transactions, up from 59% two years earlier, some sources indicate. The sector has achieved approximately 20% of its milestones, with 73% of milestones due through mid-2025 missed across a large study population. 

Those numbers are real, and the fortunate news is they do not apply to middle-market medtech business owners. The study population behind the data is venture-backed life sciences: pre-revenue and early-commercial companies whose value sits in a clinical or regulatory event that has not yet occurred. Medical devices are filed inside that category, which is why the headline appears to describe the industry. Economically, most of our clients are profitable medical device manufacturers or contract manufacturers that have almost nothing in common with the companies in that sample. However, deferred compensation can be a nice bonus for sellers seeking more valuation than the buyer is currently willing to give. But the deal must be structured properly.

Most of It Is Cash Now—Avoid Seller Financing

Among completed transactions in the $5 million to $100 million enterprise value range—privately held, owner-operated companies—consideration has been running at roughly 83% cash at close, 12% seller financing, and 4% earnout. Or, 4 cents on the dollar. In this market, the earnout is the exception rather than standard deal architecture. In our experience, though, we do not encourage any type of seller financing because there are better ways to increase stakeholder valuations. 

From product launches to M&A and manufacturing trends, the MPO Source delivers the medtech news you need twice a week. Subscribe here!

Getting the Right Multiple—The ‘X Values’

Interestingly, multiples across industries in this size band reached 5.8 times EBITDA in the second quarter of this year—the highest reading since early 2022. Eighty-seven percent of businesses sold above $5 million drew three or more offers, and a third drew 10 or more.

Two factors can lift a medtech company above that all-industry average. The first is the category: U.S. Food and Drug Administration-registered, ISO 13485-certified manufacturers generally command a premium of two to four turns of EBITDA over unregulated contract shops because the quality system, the validations, and the customer qualifications are hard to replicate. The second is the process. Our own sell-side transactions in medical technology have generally averaged eight- to 12-X. The higher EBITDA multiple is not attributable to differences in the client businesses represented in the survey; rather, it reflects the different outcome produced by a competitive process led by professionals who understand the universe of potential acquirers as opposed to a negotiation with the one buyer who makes contact. It’s important to note the same discipline that moves the multiple is what keeps the deferred piece small.

Where the Caution Belongs

Here is the finding that ought to change how a smaller business owner approaches a deal. When an earnout does appear, its share of the purchase price runs larger at the small end of the market, not smaller. Across private-company transactions with a disclosed earnout, the median earnout ran at 39.2% of total consideration in deals below $10 million and 32.7% in deals from $10 million to $100 million, against 20% in deals above $500 million. A smaller owner is less likely to face an earnout at all—and if one arrives, more of the price is riding on it, because that owner has likely never before negotiated an earnout-producing deal.

The best advice is simple: Agree only to milestones that can be controlled. Revenue from sales channels that a company may still control, a program already in the validation phases, or a facility in the process of being qualified are examples of outcomes that can be determined by controllable performance. Anything that depends on the buyer’s sales force, capital budget, regulatory team or strategic priorities is a possible bonus, not part of the price. It should be treated that way during planning and should not factor into retirement math.

Value=Strategic Fit+Timing

Six factors should be negotiated and prioritized with legal counsel before signing anything with a milestone schedule.

• Ask about standard benchmarks. Find out what a typical company in the industry would do, or what this buyer does for its own priority products. The latter is materially stronger for a seller.
• Define the milestone by outcome, not mechanism. Anything named narrowly—a pathway, a configuration, a channel—is a condition that can be taken away by someone who never signed the agreement.
• Avoid an intent-based no-frustration clause. A prohibition on actions taken for the primary purpose of defeating the milestone forces the seller to prove what a buyer was thinking. Objective operating covenants are enforceable in a way that motive is not.
• Bar the buyer from weighing the cost of the earnout. It removes the buyer’s most natural defense.
• Get information and audit rights in writing. Separate books for the acquired unit, defined regular reporting, and access sufficient to know whether the covenants are being honored.
• Plan for acceleration. If the buyer resells the business or terminates key people without cause, the schedule should respond; otherwise, the earnout depends on a company not involved in negotiations.

Here’s an additional observation from our side of the table that is not a legal point. The most effective protection against a punitive earnout is not a better clause. It is a second bidder. A buyer who knows he or she is alone writes the preferred milestone schedule; a buyer who knows he or she is not tends to move contingent dollars forward into cash. That is what a properly run process is for, and it is the part of the outcome an owner still controls.

An Encouraging Bottom Line 

The majority of the frightening numbers about medtech earnouts come from a market of pre-revenue or early-stage companies selling a future event. The market for profitable, owner-operated medical device businesses looks nothing like it, though: It involves mostly cash, multiple bidders, and multiples at a four-year high.

Where a milestone does appear, it deserves the same scrutiny as the headline price, because it represents a larger share of that price than it does anywhere else. Sellers should agree to what can be controlled, treat the rest as a bonus, and bring people who have read hundreds of these schedules to the table before signing one.

Our next column will focus on rollover equity—the other way a portion of a deal’s price gets deferred. It will also explore the question that ultimately decides what the second bite is actually worth.

More from these authors: When the Medtech Carve-Out Becomes a Competitor

Florence Joffroy-Black, CM&AA, and Dave Sheppard, CM&AA, are managing partners at MedWorld Advisors, a global M&A advisory firm serving the medical technology and life-science industries. Joffroy-Black can be reached at [email protected].

Dave Sheppard can be reached at [email protected]. This column is general commentary and not legal advice.