The Ins and Outs of Earn-Outs: A Delaware Perspective

85 Min Read By: Richard De Rose

Introduction

Earn-Outs: A Dealmaker’s Perspective

Earn-outs are an often used and potentially effective mechanism to help bridge the price gap between buyers and sellers. However, there are a number of key considerations regarding earn-outs that, if not properly considered, can lead to suboptimal outcomes.

Problem

Oftentimes, although both buyer and seller are highly motivated, their respective expectations of future financial performance of the target can be meaningfully different, creating a substantial bid-ask spread in the acquisition price.

With both parties highly motivated to finalize the deal, they are eager for ways to bridge that gap. One useful tool in this regard is the “earn-out.” However, for the dealmakers to craft an effective earn-out, they need to understand certain mechanisms of the earn-out. These mechanisms can be:

  • structuring considerations;
  • dispute resolution;
  • valuation considerations; and
  • tax considerations, to name a few.

Without grasping these key considerations, the buyer or seller may wind up disadvantaged at the time of the deal or later, when it comes time to realize the earn-out.

Therefore, it is critically important for attorneys and their clients to think through these issues fully.

Solution

Houlihan Lokey, a leading valuation and investment banking firm, has built a wealth of experience in understanding and identifying some of these considerations.

We have prepared highlights of some of the key nuts and bolts of earn-outs. We hope this information will be useful in helping you and your clients think through the various issues that can accompany an earn-out structure.


Overview of Earn-Outs: An Abbreviated Summary

This section briefly summarizes the more in-depth information that follows. For more detailed discussion of these topics, see the next section, “Understanding Earn-Outs in Detail.”

An earn-out is a provision in an acquisition agreement that makes a portion of the purchase price payable to the seller if/when certain post-closing performance targets are achieved.

Bridges the Gap Between Buyer and Seller

Situations where the seller’s optimism contrasts with the buyer’s skepticism can often be found in businesses with:

  • limited operating history,
  • financial distress,
  • a historical pattern of not meeting budgets/forecasts,
  • an uncertain business environment with unusually high volatility (e.g., COVID-19), or
  • an unproven product or new market for an existing product.
Commonly Used

Earn-outs are found in nearly 30 percent of M&A deals, but are more typical in private deals with deal values under $250 million. An earn-out can mitigate risk for the buyer, while giving the seller an opportunity to enhance the aggregate consideration. A poorly structured earn-out can result in mismanagement of the newly acquired business and lead to post-deal disputes.

“[A]n earn-out…typically reflects [a] disagreement over the value of the business that is bridged when the seller trades the certainty of less cash at closing for the prospect of more cash over time…But since value is frequently debatable and the causes of underperformance equally so, an earn-out often converts today’s disagreement over price into tomorrow’s litigation over the outcome.”[1]

The challenge in crafting an earn-out is to reconcile the parties’ competing priorities and their desire to shift as much post-closing risk as possible to the other party.

Buyer Considerations
  • Could result in a higher purchase price if the acquired business proves successful
  • May result in restrictions in operating the newly acquired business
  • The chosen measure for the achievement of earn-out may be poorly defined and not ultimately as meaningful or relevant
Seller Considerations
  • Underperformance can lead to reduced purchase price
  • Postponing payment increases the risks of external impact adversely impacting the aggregate purchase price paid
  • Seller may surrender control to the buyer and/or be adversely impacted by the buyer’s business, making it more difficult to achieve the earn-out

Structuring Earn-Outs

Each earn-out is unique, but several provisions are usually addressed—and if not, post-deal disputes may ensue.

Key Provisions to Be Addressed
  • Defining the Business
  • Relevant Performance Metrics
    • Financial metrics (e.g., revenue, EBITDA, net income, etc.)
    • Thresholds
    • The required level of the financial metric
    • Milestones
    • Non-financial (e.g., FDA approval of a drug)
  • Measurement Standards
    • GAAP and/or exceptions to GAAP
  • Form of Consideration
    • Securities law issues
  • Earn-Out Period
    • Buyer/seller considerations with respect to the period
    • Sufficient to assess performance of the business
    • 1–3 years is common
  • Operational Control
    • Critical Issue: buyer flexibility to run the business versus the seller’s desire to maximize the earn-out
  • Payout Formula
    • Binary
    • All or nothing; more common with milestones
    • Graduated (e.g., [x]% of adjusted EBITDA)
    • Multiple (e.g., milestone plus a revenue threshold)
    • Caps/floors
    • Maximum/minimum payouts under the earn-out
    • Payout schedules
    • One or several payouts
    • Indemnification
    • Offsets against amounts due to the buyer

Dispute Resolution

A large body of Delaware case law suggests that earn-outs tend to only postpone disputes because cases typically involve a business’s failure to meet earn-out criteria. Key considerations concerning earn-out-related disputes include payout calculation, arbitration vs. litigation, and breach of contract or breach of the implied covenant of good faith and fair dealing.

Delaware courts interpret earn-out provisions literally, and intent of the parties is paramount. Resorting to good-faith provisions can be problematic. Sellers may claim, among other things, that the payout calculation was incorrect or there were certain breaches by the buyer.

Payout Calculation Disputes

If the buyer and seller disagree initially on the payout calculation, the agreements typically would call for an expert or arbitrator (a “neutral”) to make a final determination. (An expert or arbitrator is an important distinction with significant consequences.)

Note, Delaware courts will not lightly intervene in payout calculation disputes, which may lead to pursuit of other legal actions. Therefore, it is important for the agreement to distinguish payout calculation and other causes of action, which would be resolved in a different manner.

Payout Calculation Considerations

Relevant concerns that should be addressed in the provisions regarding the payout provisions include:

  • how the neutral will be selected
  • the scope of review and whether the neutral will be an expert or arbitrator
  • who pays
  • whether the neutral will be bound by methodologies provided for in the agreement or can raise issues beyond those identified by the parties
  • the timetable
  • the basis for dispute of the neutral’s conclusion

Agreements sometimes include mandatory arbitration as the primary means of dispute resolution. However, litigation may arise over whether a court or an arbitrator has jurisdiction to make certain determinations.

Arbitration vs. Litigation

Some advantages of arbitration include speed, cost-effectiveness, and enhanced confidentiality. However, some advantages of litigation may include discovery, definitive resolution, availability of appeal, and alleviation of concerns over arbitrator competency or seeking a compromise value.

Breach of Contract

Losing sellers sometimes recast claims in a subsequent lawsuit alleging breach or express or implied obligations. This is a high bar. Delaware recognizes an implied covenant of good faith and fair dealing, which serves as a gap-filling role. Sellers will argue that the buyer may not undermine the business and that the implied covenant might obligate the buyer to take reasonable measures to achieve the earn-out. Buyers argue that there are no gaps to fill and that the implied covenant does not provide protections not secured at the time of the original agreement.

Valuation of Earn-Outs

There are a number of considerations for how an earn-out is treated for accounting purposes, and there are multiple ways to value the earn-out.

Accounting Treatment

An earn-out is treated as a liability if payment involves cash or variable number of shares. The liability must be remeasured to fair value at each reporting period until contingency is extinguished and associated change is recorded as a gain or loss on the income statement. If opening liability is greater than the payout, a loss is recorded, or vice versa. If payment involves a fixed number of shares, it is treated as equity.

How an earn-out is treated can impact the buyer’s income statement (e.g., EBITDA) and, thereby, may have an impact on certain other aspects of its business (e.g., bank financial covenant measurements).

Earn-Out Methodologies

There are two different valuation methodologies: the scenario-based method (SBM) and the option pricing method (OPM). In the SBM, multiple scenarios are identified. A payout is calculated for and a probability assigned to each, and an averaged payout is discounted at a risk-adjusted discount rate.

The OPM is better suited for non-linear payout structures or when multiple metrics involved. It treats earn-outs like a call option and employs option pricing models (e.g., Black-Scholes).

Tax Issues

The parties may have adverse tax interests in the characterization of payouts, so the treatment of the earn-out should be addressed as early as possible.

Tax Considerations for Parties
  • Compensation or purchase consideration
    • Compensation taxed as ordinary income to the seller, with a deduction for the buyer
    • Consideration taxed as capital gain to the seller, and the cost is capitalized for the buyer
  • Magnitude of payout
    • Should any tax sharing agreements be factored in as part of achieving thresholds?
IRS Considerations
  • Is the seller required to provide services to be eligible for payout?
  • Is the seller otherwise adequately compensated for services?
  • Are payouts proportionate to seller’s equity?
  • Do total payouts represent a reasonable price paid to seller?
  • What is the compensation of non-selling carryover employees?
  • How is the earn-out treated for tax and financial reporting purposes?

Contingent Value Rights

Contingent Value Rights (CVRs) represent a version of the earn-out in transactions involving publicly traded companies, and they are particularly common in the pharma-life sciences sector.

Tax Considerations for Parties
  • Typically, shorter in duration than traditional earn-outs and tied to an objectively verifiable outcome (e.g., FDA approval of a new drug).
  • Can be considered a security, subjecting it to registration requirements of the Securities Act
Five Factors

The SEC sets out five essential factors for CVRs not to be considered a security:

  1. Integral part of transaction
  2. Not represented by any form of certificate or instrument
  3. No rights common to stockholders (e.g., voting) and does not bear a stated interest rate
  4. Does not represent an equity or ownership interest
  5. Not transferable

Understanding Earn-Outs in Detail

What Is an Earn-Out?

  • An earn-out is a provision in an acquisition agreement (the agreement) that makes a portion of the purchase price for a target company or business (the business) payable to the seller of the business (the seller) based on the post-closing performance of the business.
  • Twenty-seven percent of the deals in the ABA’s 2018–1Q2019 Private Target M&A Deal Points Study (the ABA Study) featured an earn-out.
  • Earn-outs most often are found in private company acquisitions with a value of under $250 million.[2]The size of an earn-out relative to the total consideration in the transaction will typically reflect the magnitude of the disagreement between the parties with respect to the value of the business. An earn-out representing less than 15 percent of the purchase price may not be worth the time and effort to negotiate the earn-out provisions and/or the risk of future litigation.[3]
  • Payments of deferred purchase price and post-closing purchase price adjustments are not earn-outs.
    • A purchase price deferral is effectively a loan by the seller of a portion of the purchase price to the buyer of the business (the buyer).
    • Purchase price adjustments reflect changes in the working capital of the business between the signing of the agreement and closing and can increase or decrease the purchase price for the business, whereas earn-outs will only increase the purchase price in the future.
  • An earn-out in the context of a public company acquisition is known as a “contingent value right.” See the “Contingent Value Rights” section later in this article for more information.

When to Use an Earn-Out

  • Earn-outs can potentially bridge a gap between parties with differing views as to the business’s prospects and/or value.
    • An ex post “true-up” allows the parties to agree to disagree and complete the acquisition of the business (the acquisition).
  • Among other things, earn-outs may be particularly useful in situations involving a(n):
    • Business with a limited operating history but with significant growth potential,
    • Uncertain economic environment or a highly volatile industry,
    • Business with a historical inability to achieve its projections,
    • Unproven product or a new market for an existing product,
    • Business having recently undergone a financial or operational restructuring,
    • Company that has experienced a recent drop in earnings that may be temporary (e.g., due to COVID-19),
    • Business that is dependent on relatively few customers, or
    • Buyer with limited access to debt financing.
  • Properly structured, an earn-out can produce a win-win situation for both seller and buyer.

Advantages of an Earn-Out to the Buyer

Earn-out payments can be used to secure the seller’s indemnification obligations under an agreement. They provide the potential for greater aggregate consideration than in a fixed price structure (especially for the seller of a financially distressed business). And earn-out payments may allow the seller to benefit from synergies achieved by integrating the business with the buyer, allow for deferral of taxes (see the “Tax Issues” section for further discussion), and may allow the seller to control its own destiny if the incumbent management manages the business post closing.

Considerations Regarding Earn-Outs

A poorly crafted earn-out can result in mismanagement of the business and can create contentious post-deal disputes. As Vice Chancellor Laster of the Delaware Chancery Court (the Court) observed in Airborne Health:[4]

“[A]n earn-out…typically reflects [a] disagreement over the value of the business that is bridged when the seller trades the certainty of less cash at closing for the prospect of more cash over time…But since value is frequently debatable and the causes of underperformance equally so, an earn-out often converts today’s disagreement over price into tomorrow’s litigation over the outcome.”

The challenge in crafting an earn-out is to reconcile the parties’ competing priorities and their desire to shift as much post-closing risk as possible to the other party.

Buyers will want to (i) control the post-closing activities of the business and (ii) minimize the future earn-out payments. Sellers will want the buyer to (i) actively pursue the growth of the business and (ii) maximize the future earn-out payments. Structuring an earn-out usually involves complex accounting, valuation, and tax issues that require the involvement of expert advisors. Because it is impossible to anticipate and address every scenario that could impact the earn-out, there is usually a “trust-me” aspect to the negotiation.

Buyer Considerations
  • If the acquisition is successful, the buyer may pay more for the business than if it had paid a higher price up front.
  • An earn-out may impose restrictions and covenants on the buyer, including restrictions on integrating the business.
  • The seller may benefit from enhancements to the business contributed by the buyer after closing.
  • Due to unexpected changes, the chosen measure of success at closing may not be a relevant metric in the future.
  • If incumbent management continues to operate the business, short-term, earn-out targets may undermine the buyer’s long-term goals.
Seller Considerations
  • If the business underperforms, the seller will receive less consideration than anticipated.
  • The seller may lose the ability to influence decisions that affect the achievement of the full earn-out.
  • The business may be affected by exogenous post-closing factors that were not anticipated when the agreement was signed.
  • The buyer may not be motivated to improve the performance of the business during the pendency of the earn-out period.
  • Financial support from the buyer may be critical to achieving the business’s projections.
  • The seller is likely to lose custody of the books and records of the business (see Windy City).
  • The seller is vulnerable to the credit risk of the buyer.

Structuring Earn-Outs

Earn-outs are bespoke provisions; however, several key areas are typically addressed:

  • definition of the business on which the earn-out will be based,
  • relevant performance metric(s),
  • appropriate target(s) for achieving the earn-out,
  • amount to be paid if the earn-out target(s) are achieved (the payout),
  • appropriate standard for measuring the performance of the business (the performance metric),
  • formula that will quantify the payout,
  • appropriate time period for achieving the earn-out (the earn-out period),
  • allocation of post-closing control of the business, and
  • mechanisms for dispute resolution.

Defining the Business

If operated ex post as a subsidiary or segregated division, measuring the business’s performance should be relatively straightforward. Integration of the business with the buyer can make a pre- and post-comparison of performance of the business difficult.

The following matters, among others, should be considered in defining the business:

  • the specific line(s) of business to be included (by business line, customer type, price point, or region, etc.) (See Windy City);
  • whether expansion of the business by the buyer will count toward the earn-out (see Glidepath and Western Standard); and
  • the treatment of revenue from pre-closing customers common to the business and the buyer.

Performance Metrics

The performance metrics can be (i) financial, (ii) non-financial, or (iii) a combination of both.

Financial Performance Metrics

Financial performance metrics include income statement line items (for example, net revenues, EBITDA, net income), balance sheet items (e.g., net equity), or other performance metrics (such as buyer’s stock price).

Sellers prefer revenue-based performance metrics, which are less impacted by expenses and buyer post-closing accounting practices.

Buyers, on the other hand, prefer income performance metrics, as they can be better indicators of the success of the business. Buyers are more likely to insist on net income if incumbent management will operate the business post closing (to incent cost control).

Earnings before interest, taxes, and depreciation and amortization (EBITDA) is a commonly used financial performance metric. Because the aggregate purchase price is often calculated as a multiple of EBITDA, it is logical to use the same measure for the earn-out.[5] EBITDA is not defined under generally accepted accounting principles (GAAP) and may not be presented in the historical financials of the business. Accordingly, the items to be included/excluded in calculating EBITDA need to be clearly specified in the agreement.

Thresholds

The earn-out threshold (the threshold) is the financial performance metric level that the business must achieve for the seller to receive a payout. Thresholds are typically based on the seller’s projections for the business (the projections). Thresholds should be objective and measurable, plainly defined, and consistent with the character of the business.

Milestones

Non-financial performance metrics commonly include regulatory approval or the launch of a new product (a milestone and, together with a threshold, a target). Milestones obviate many of the complexities associated with structuring financial thresholds. However, an issue can arise as to whether a milestone can be achieved in part, but not in whole, (e.g., if only some of the claims of a patent are granted (see Gilead Sciences and Allergan)).

Milestones are especially useful in the context of emerging companies, where setting financial thresholds may be challenging due to the high growth trajectory of the business and/or the lack of historical information to use as a baseline. Milestones are most frequently observed in life sciences (FDA approval of a drug) and in technology (receipt of a patent).

A milestone structure requires the parties to agree on:

  • the specific milestone (see Gilead Sciences),
  • the specified degree of buyer efforts to cause, or to cooperate in causing, the milestone event to occur (see Allergan), and
  • any deadline by which the milestone must occur (see Shire).

The most successful milestone is either an event over which neither the buyer nor the seller has any control or an event that is so important, the buyer remains motivated to see that event occur, despite the obligation to make the milestone payout.

The parties should be very specific as to what types of approval satisfies a milestone. The use of industry and colloquial terms in defining the milestone (on the assumption everyone knows what is meant) can lead to subsequent disputes (see Valeant). Examples should be included in the agreement of what will, and what will not, satisfy the milestone (see Shire and Tutor Perini II). Parties should also ensure that documents outside the agreement, such as term sheets and board presentations, clearly and consistently describe any milestones.

Measurement Standards

Earn-outs based on financial performance metrics require that the post-closing financial statements allow the performance of the business to be accurately compared to the relevant threshold.

The seller’s goal will be to ensure that the earn-out calculation provides an “apples-to-apples” comparison between the pre-closing and post-closing performance of the business. The baseline methodology is usually GAAP, applied consistently with the seller’s pre-closing practices.

Reference to GAAP alone, however, is insufficient, as GAAP permits a wide range of accounting policies (see Chambers).

Some of the accounting issues that are commonly prone to dispute include, among others:

  • inventory valuation: excess and obsolescence reserves (see Winshall I);
  • collectability of accounts receivable and bad debt allowances (see Tutor Perini II);
  • current expense versus capitalization (see Chambers);
  • reserves for warranty and product returns and for pension and post-retirement benefits;
  • contingencies such as litigation and environmental clean-up; and
  • changes to conform to newly promulgated GAAP.

The parties and their advisors need to identify and agree on line items that will be a supplement (or an exception) to GAAP. Adjustments specified in the agreement take precedence over GAAP (see Chambers and LaPoint). The agreement should set forth in detail how the financial performance metric should be calculated, including how specific line items would impact the calculation. Illustrative calculations can be helpful in resolving later disputes (see Tutor Perini I). In particular, matters commonly addressed in determining a financial performance metric include, among others:

  • costs and expenses incurred in connection with the acquisition (see Chambers and Comet Systems);
  • allocation of intercompany overhead for home office services;
  • determination of appropriate transfer pricing in intercompany transactions;
  • treatment of extraordinary or non-recurring items of gain or loss (see Comet Systems);
  • revenues and expenses from new lines of business not contemplated by the agreement;
  • capital expenditures and R&D costs, the benefit of which accrue after the earn-out;
  • management or other fees charged to the business;
  • the treatment of discontinued operations; and
  • the treatment of synergies arising from the acquisition.

Payout Formula

Once the performance metric(s), threshold(s), and measurement standards are established, the parties need to agree on whether the payout will be structured as a fixed percentage of an underlying performance metric or as a complex, nonlinear function of the underlying performance metric, which can feature floors, caps, and catch-up or make-whole provisions (the payout formula).

Binary Payout Formulas

Under a binary or an “all-or-nothing” payout formula, a lump sum is payable only upon the achievement of a stated target (e.g., $10 million upon the launch of Product X). Binary payout formulas are more commonly found in earn-outs with non-financial milestones, such as regulatory approvals. A binary payout formula can incentivize the buyer or an incumbent management to take actions to miss or achieve the threshold, as the case may be. A binary payout formula can demotivate an incumbent management when it becomes apparent that the business will not be able to achieve a required target.

Graduated Payout Formulas

Given the negative incentives of a binary payout formula, sellers will try to negotiate a payout formula that is a percentage of the performance threshold (e.g., “the annual payout shall equal 5 percent of adjusted EBITDA” or a graduated payout formula). Graduated payout formulas are relatively uncommon, as buyers resist paying for performance that does not achieve the relevant target.

The compromise is to set a minimum threshold (e.g., “the payout shall be 15 percent of the excess of 2021 EBITDA over $5 million”).

Multiple Payout Formulas

Payout formulas can include more than one performance metric (e.g., satisfaction of two of the following: (i) a revenue threshold, (ii) an EBITDA threshold, and/or (iii) retention of X% of the business’s customers).

Multiple performance metrics reduce the opportunity for a buyer or an incumbent management to manipulate the earn-out.

Caps and Floors

The payout in an earn-out can become substantial if the achieved performance metric exceeds the threshold by a significant amount. Buyers will want to cap the amount of each payout or the aggregate of all payouts (see Tutor Perini and Windy City). Sellers will try to resist any caps and will try to negotiate for a minimum floor payout (see Windy City).

Including floors and caps narrows the range of potential discrepancy that can be subject to subsequent dispute.

Payout Schedule

Payouts may be in one payment at the end of a short earn-out period or in periodic installments over a longer earn-out period. Multiple installment payouts raise a number of complicated issues:

  • The buyer may want to set near-term payouts at a lower percentage than later ones to protect against future shortfalls but, conversely, may want to decrease the payout over time to reflect any synergies from integrating the business with the buyer.
  • If the business fails to achieve the threshold in one period but exceeds it in the following period, the buyer may require that the seller make up the prior deficiency before becoming entitled to receive the current year payout.
  • Similarly, if the business achieves the threshold in an earlier period but fails to achieve it in later periods, the buyer may seek to “claw back” all or a portion of the prior year payout.
  • Conversely, the seller will want to be able to make up any deficiencies in performance in one period with any excess in a prior or later period to achieve the target for the deficient period (see Tutor Perini).

Such complexities can be avoided through the use of a cumulative approach, which depends on the extent to which the average results during the earn-out period exceed a specified cumulative threshold.

Interaction with Indemnification

The agreement should specify any interaction between the seller’s indemnification obligations and the earn-out provisions. Buyers will want the right to offset payouts against amounts due pursuant to the seller’s indemnity under the agreement.[6]Buyers will resist having the earn-out be the sole source of indemnity payment inasmuch as the earn-out may never be earned. Sellers will want to ensure that a given event does not give rise to both an earn-out offset and a separate indemnity claim.

Form of Consideration

Payouts may take the form of cash or non-cash consideration, such as a buyer note or stock, or both. If the consideration is cash or a buyer note, the seller will assume the buyer’s credit risk and will want assurances that the buyer will be able to make required payouts when due, and they may request security in the form of an escrow.

Sellers will want to ensure that the buyer’s credit facilities (existing and, if possible, future) will not impact the buyer’s ability to make the required payouts when due. The seller may ask for interest to begin accruing at a punitive rate if the buyer does not make a required payout when due.

If payouts are to be made in buyer stock, the agreement will need to address a number of issues pertaining to:

  • the date as of which the value of the buyer stock will be measured (e.g., the closing or issue date),
  • the seller’s registration rights, if any,
  • any voting restrictions/requirements,
  • tag-along/drag-along rights,
  • repurchase right by the buyer,
  • restrictions on transferability, and
  • anti-dilution protection.

If the buyer is a private company, the parties will need to specify a valuation methodology (e.g., formula or third-party valuation). The seller will want to ensure that the maximum number of potentially issuable shares of buyer stock are reserved at closing and any required stockholder approvals are secured.

Securities Law Issues

The Securities Exchange Commission (SEC) has issued numerous no-action letters on the subject of whether an earn-out is a security and considers many factors when making this determination, including whether:

  • the earn-out is an integral part of the consideration to be received in the acquisition;
  • the earn-out right is represented by any form of certificate or instrument;
  • the holders of the earn-out have rights in common with stockholders (for example, voting and dividend rights);
  • the earn-out represents an equity or ownership interest in the buyer; and
  • the earn-out is transferable.

The Earn-Out Period

Once the appropriate performance metrics, targets, and payout formulas have been agreed upon, the parties will need to consider the length of the earn-out period, the end of which may be triggered by the passage of time or the occurrence of an agreed-upon event. The earn-out period should be sufficient to adequately assess the performance of the business. An earn-out period that is too short carries the risk that performance of the business may be distorted by temporary short-term factors, such as COVID-19 or a drop in the price of oil. An earn-out period of one to three years after closing is common.[7]

Buyer Considerations

Buyers prefer shorter earn-out periods to minimize the duration of any restrictions on their management of the business. The buyer may want an early buyout option in the event the earn-out hinders the buyer’s ability to operate the business. Ideally, the price of any buyout should be a fixed dollar amount to avoid interim payout calculation disputes. However, if incumbent management is to manage the business, an earn-out period that is too short might provide an incentive to sacrifice the buyer’s long-term interests for short-term profits. If financing is an issue, the buyer may prefer a longer earn-out period to have more time to actually make the required payout.

Seller Considerations

A shorter earn-out period can result in an earlier potential payout.

If incumbent management is running the business post closing, a longer earn-out period will provide more time to achieve the relevant target; however, a longer earn-out period reduces the present value of the consideration ultimately received. Sellers will want to include a provision that accelerates the payout upon the occurrence of certain events that might negatively impact the ability of the business to achieve its target, including, among other things:

  • a sale of all or a substantial portion of the business,
  • a change in control of the buyer,[8]
  • a default under any of the buyer’s credit facilities or other material contracts, and
  • termination of incumbent management for any reason.

Operating Control Issues

Two of the most difficult, albeit most important, aspects of structuring an earn-out are determining:

  • the degree of control (if any) that the seller will have over the business post closing, and
  • the level of support (if any) that the buyer will be obligated to provide to the business.

Balancing the buyer’s desire to run the business as it sees fit and the seller’s desire to protect the business’s ability to achieve its target(s) can be difficult and often leads to disputes.

Buyer Considerations
  • The buyer will want to negotiate for:
  • the right to operate the business in its sole discretion[9] (see LaPoint) and
  • a disclaimer of fiduciary duty to the seller regarding the earn-out.[10]

If the business is to be run by an incumbent management, the buyer will want covenants and restrictions in the agreement to ensure the business is not operated solely to maximize the payout through risk-taking or failure to invest. An incumbent management may face potential fiduciary duty conflicts. As employees of the buyer, incumbent management will have an obligation to do what is best for the parent corporation, even if that means taking actions that could adversely affect the business and reduce the likelihood of receiving a payout.

Seller Considerations

Sellers will seek to impose certain restrictions on a buyer’s operation of the business, including obligations for the buyer to:

  • run the business to maximize the earn-out,[11]
  • operate the business consistent with past practice,[12]
  • use “commercially reasonable” efforts to achieve a target (see Allergan),
  • not take any action with the intent of decreasing the amount of any payouts,
  • provide the business with appropriate levels of working capital and capital expenditures,
  • maintain the existing research and development programs, and
  • not divert business to other entities controlled by the buyer.

The seller will also try to reserve some authority regarding major decisions by the buyer, including restrictions on:

  • disposing of all or a significant portion of the business,
  • hiring or firing of incumbent management,
  • restrictions on dividends from the business,
  • incurrence of additional debt, and
  • combining all or a significant part of the businesses with another company or business.

Dispute Resolution

Unfortunately, as observed by Vice Chancellor Laster in Airborne Health, earn-outs often merely postpone disputes, as is evidenced by the large body of Delaware case law respecting earn-outs. Though fact-specific, the cases usually involve a failure of the business to meet its target, followed by the seller’s claim the:

  • payout calculation was incorrect,
  • buyer breached the agreement, and/or
  • buyer breached the implied covenant of good faith and fair dealing (the implied covenant).

As with other contract provisions, when Delaware courts interpret earn-out provisions, the intent of the parties is paramount. An agreement’s plain language will be enforced notwithstanding a windfall to one of the parties (see Chambers and LaPoint). If the agreement is unambiguous, extrinsic evidence as to the intent of the parties will not be admissible (see Exelon Generation).

Ambiguous provisions are likely to result in a trial (see Stora Enso, Western Standard, and Windy City). The Court is unlikely to aid a sophisticated party that could have, but failed to, negotiate contractual protections (see Airborne Health). Recognizing the futility of trying to provide for every contingency, parties often resort to good-faith provisions in the agreement (usually at the seller’s request). The Court has criticized such provisions as “gossamer definitions” and “aspirational statements” that are “too fragile to prevent the parties from devolving into…dispute” (see LaPoint).

Payout Calculation Disputes

In the typical scenario, the buyer’s accountants prepare the post-closing financial statements and calculate the payout amount. The seller then has a period of time either to submit a notice of disagreement or to accept the calculation as final and binding. The buyer will often try to limit the seller’s scope of objections to factual or numerical mistakes, or inconsistencies with the agreement.

Failing a negotiated resolution of any disputes, the agreement frequently provides for the parties to jointly select an accountant from a third independent accounting firm (a neutral accountant), whose determination will be final. Whether a chosen neutral accountant is denominated as an expert or as an arbitrator can have serious ramifications. See Chicago Bridge & Iron Co. N.V. v. Westinghouse Elec. Co. LLC, 166 A.3rd 912 (Del. 2017) (Chicago Bridge). An expert determination is merely a determination of a specific factual issue that the agreement requires to be determined by an expert.

In contrast, an arbitrator’s powers are analogous to those of a judge and include, among other things, the power to interpret contracts, resolve factual disputes, determine liability, and award damages. An arbitrator’s award is enforceable by a court, with limited right to appeal or review under the Federal Arbitration Act (FAA).

Delaware courts will not lightly intervene in disputes over payout calculations when the agreement provides for arbitration and is likely to treat a neutral accountant’s resolution as final. The Delaware Supreme Court (DSC) has held that the courts have no role in considering disputes where the “plain language of the…agreement” made arbitration by [a neutral accountant]…the “mandatory path” for resolving disputes over a post-closing adjustment. (See Chicago Bridge. See also MarkDutchCo.)

There are important differences between a payout calculation (addressed by the neutral accountant) and potential causes of action, such as fraud or a breach of the agreement, which are not suitable for expert determination. The agreement should carefully distinguish and separate payout calculation disputes from such other potential issues. Relevant concerns in drafting a payout calculation dispute provision will include:

  • how the neutral accountant will be selected,
  • the scope of review by the neutral accountant (solely the payout calculation as an expert or “any and all disputes” as an arbitrator),
  • who will pay for the neutral accountant (the loser, or shared equally or proportionally) (see MarkDutchCo),
  • whether the neutral accountant is bound by the methodologies provided in the agreement,
  • whether the neutral accountant can raise issues beyond those identified by the parties (see Chicago Bridge),
  • what work papers will be provided in support of the neutral accountant’s calculation,
  • whether the neutral accountant is free to perform a de novo calculation to derive its own result,
  • a timetable for the process, and
  • the basis on which, if any, a party can bring a claim to dispute the neutral accountant’s determination.

The neutral accountant’s engagement letter is important because the scope of its mandate can be opened up beyond what was contemplated in the agreement if the parties agree to a wider scope in the engagement letter.

General Arbitration vs. Litigation

Agreements sometimes include mandatory arbitration as the primary means of dispute resolution. Factors favoring arbitration over litigation include speed, reduced expense, and enhanced confidentiality. On the other hand, factors favoring litigation include more expansive discovery, definitive resolution of legal issues, the availability of plenary appeal, concern over the competence of the arbitrator pool, and concern that an arbitrator will gravitate toward compromise outcomes.

Litigation can arise over whether a court or an arbitrator has jurisdiction to make certain determinations. The DSC has stated that:

“Issues of substantive arbitrability are gateway questions relating to the scope of an arbitration provision and its applicability to a given dispute, and are presumptively decided by the [C]ourt. Procedural arbitrability issues concern whether the parties have complied with the terms of an arbitration provision and are presumptively handled by arbitrators. These issues include whether prerequisites such as time limits, notice, laches, estoppel, and other conditions precedent to an obligation to arbitrate have been met, as well as allegations of waiver, delay, or a like defense to arbitrability.” (See Winshall I)

Once jurisdiction has been resolved, a Delaware court will likely take an expansive view of the competence of an arbitrator to decide a broad range of matters, including procedural questions as well as interpretation of the agreement and applicable law. Many of the same considerations apply to the appointment of a general arbitrator as pertain to the retention of a neutral accountant. If the agreement allows recourse to litigation, jurisdiction and venue should be clearly specified.

Breach of Contract

Losing sellers in payout calculation disputes often try to recast their claims in a subsequent lawsuit alleging that the failure of the business to achieve a target was due to the buyer’s breach of an express or implied obligation under the agreement.

Sellers (as the usual plaintiff in these cases) face an uphill battle in proving not only the buyer’s misconduct but also that such misconduct caused the business to miss its target. (See LPL Holdings and En Pointe.) The high bar results in many earn-out cases being dismissed at the motion to dismiss or summary judgment stage.

Delaware courts often hold that the buyer’s conduct reflected the exercise of legitimate business judgment and that the seller’s complaint is merely a dispute over business strategy. (See Lazard Technology, Boston Scientific, and Glidepath.) However, a claim based on the manner in which the business was operated post closing may involve factual determinations that will preclude a successful motion to dismiss. (See Edinburgh Holdings and Cephalon.)

Proving whether the seller has been damaged—and in what amount—requires expert testimony, especially when the business is a startup or has a limited track record, which makes it difficult to quantify how the buyer’s actions or inactions harmed the business. It can be difficult to prove that targets would have been reached but for breaches by the buyer, and the Court may be reluctant to speculate what the payout would have been in the absence of the breach. (See LaPoint and LPL Holdings.) The seller might consider seeking to specify remedies for breaches of any of the obligations or restrictions regarding the post-closing operation of the business—such as liquidated damages or payment of the maximum payout.

Breach of the Implied Covenant

Delaware recognizes an implied covenant that “requires a party in a contractual relationship to refrain from arbitrary or unreasonable conduct which has the effect of preventing the other party to the contract from receiving the fruits of the bargain.” (See Winshall II.) The implied covenant serves a gap-filling function where the parties to the agreement did not anticipate some contingency, and had they thought of it, the parties would have agreed at the time of contracting to address that contingency. (See LPL Holdings.)

Sellers will argue that a buyer may not undermine the business and thereby deprive the seller of its “fruits of the bargain,” i.e., a payout. Sellers often further argue that the implied covenant obligates the buyer to take “reasonable” or even “best efforts” to reach a target.

The Court has held that the implied covenant does not impose a duty on a buyer to maximize an earn-out and does not “give the plaintiffs contractual protections that ‘they failed to secure for themselves at the bargaining table.’” (See En Pointe and Winshall II.) On the other hand, the Court is not tolerant of actions by a buyer that demonstrate an attempt to divert resources, opportunities, or revenue away from the business to avoid paying an earn-out. (See LPL Holdings and Haney.) Buyers defend against implied covenant attacks by emphasizing that the implied covenant is inapplicable when “the subject at issue is expressly covered by the contract.” (See Airborne Health, Lazard Technology, and Dialog Semiconductor.)

However, the Court has sometimes recognized claims for breach of the implied covenant where “the contracting parties would have agreed to proscribe the act later complained of…had they thought to negotiate with respect to that matter.” (See Winshall I.) The Court will not countenance a claim for breach of the implied covenant if such claim is duplicative of a related breach of contract claim. (See Edinburgh Holdings.)

Valuation of Earn-Outs

Accounting Standards

Under FASB ASC Topic 805 (Topic 805), the fair value of an earn-out is required to be recorded as a liability (the opening liability) on the buyer’s balance sheet if the payout involves the payment of cash or the issuance of a variable number of shares of buyer common stock. If the payout is in a fixed number of shares, it is classified as equity.

An earn-out recognized as a liability must be remeasured to fair value at each reporting period until the contingency is extinguished. To the extent there is a change in fair value, the change must be recognized as gain or loss on the buyer’s income statement. Contingent consideration recorded in equity is not required to be remeasured.

The accounting treatment for an earn-out is somewhat counterintuitive. If the opening liability is less than the payout, a loss is recorded (though the business is actually performing better than expected). On the other hand, if the opening liability is higher than the payout, a gain is recorded (though the business is not performing up to expectations).

The accounting for earn-outs can distort or skew a buyer’s EBITDA. If the business performs better than expected, the buyer may be required to book a loss, thereby reducing its EBITDA. The parties will also need to determine if and how such gains and losses figure into the payout calculation. A buyer also needs to address whether these types of gains and losses should be excluded in calculating leverage ratios in its credit and other material agreements.

Valuation Methods

In an effort to standardize the methodologies being used to value contingent consideration, in February 2019, the Appraisal Institute issued its “Valuation Advisory #4: Valuation of Contingent Consideration” (the Advisory), which suggested two primary methodologies for valuing earn-outs: the scenario-based method and the option pricing method.

Scenario-Based Method (SBM)

Under the SBM, multiple possible scenarios are identified for the underlying performance metric. A payout, if any, is calculated for each scenario and is weighted with an estimated probability factor. The weighted average payout calculated from the scenarios is then discounted to present value using a risk-adjusted discount rate. The choice of discount rate for the SBM should reflect the riskiness of the underlying performance metric.

Although the industry-weighted average cost of capital (WACC) is a reasonable starting point, other factors to consider include, among other things, the risk of buyer default on the payout and whether the earn-out is more or less risky than typical industry cash flows. Another alternative is to use the WACC that was used to calculate the enterprise value of the business in the acquisition, adjusted for any risks arising after the agreement was signed.

Milestone-based earn-outs are not exposed to market risk and are valued using a risk-free rate to discount probability-weighted payouts.

A standard discounted cash flow analysis (a DCF) is a form of SBM with only a single scenario representing an expected case. When valuing an earn-out using a DCF, the performance metric for the business is forecasted over the earn-out period and is compared to the relevant target to determine any payouts, which are then discounted to present value as of the acquisition date.

Generally, a DCF analysis is appropriate only when valuing an earn-out with a linear percentage payout formula. For example, an earn-out with a payout equal to 30 percent of the next fiscal year’s EBITDA is linear because it has a constant relationship to the underlying performance metric (i.e., a payout is due whether EBITDA is $1 million or $100 million).

Option Pricing Method (OPM)

The SBM approach is not well suited to capture the economics of more complex nonlinear structures, which feature, e.g., thresholds or caps, or where there are multiple performance metrics at play. The valuation of such complex payout formulas requires more sophisticated probabilistic methodologies, such as OPM, which incorporate assumptions about the full range of future outcomes rather than just a sampling of possible scenarios. Payout formulas that have a nonlinear structure are similar to options in that they are triggered when certain thresholds are reached.

The OPM treats earn-outs like call options on the future payouts and uses option models such as Black-Scholes. Option models work for simpler payout formulas, under which a payout is earned only if the business hits a target, or for linear graduated payout formulas with caps or floors.

For complex payout formulas that are path-dependent (e.g., where there are catch-ups, claw-backs, or multi-year features), a Monte Carlo simulation may be required.

Tax Issues

The parties may have adverse tax interests in the characterization of payouts, so the treatment should be addressed as early as possible. If treated as compensation for services, the payout will be treated as ordinary income to the seller (i.e., a negative implication) but will provide a compensation deduction to the buyer (i.e., a positive implication).

Alternatively, if the payout is treated as purchase price, the seller will be taxed at the lower capital gain rate (i.e., a positive implication), but the buyer will have to capitalize the cost (i.e., a negative implication).

The Internal Revenue Service will consider the facts and circumstances surrounding the payouts and has historically focused on the following factors:

  • whether the seller is required to provide services in order to be eligible for the payout;
  • whether the seller is otherwise adequately compensated for the performance of any required services;
  • whether the Payouts are proportionate to the seller’s equity in the business;
  • whether the total payouts made to the seller when viewed together with any upfront cash payments represent a reasonable price to be paid for the business;
  • the manner in which non-selling carryover employees are compensated for post-closing service; and
  • how the parties report the payouts for both tax and financial reporting purposes.

When a payout is properly considered compensation for services, it will be treated as taxable income when received by the service provider. The timing of the related deduction will depend upon the accounting method of the buyer. If the payout is treated as purchase price, special rules related to installment sales may apply. Additionally, an imputed interest component may apply to the deemed installment sale.

Other considerations with respect to earn-out payments:

  • The size of any cash payouts should not be of a magnitude to threaten a tax-free reorganization.
  • The size of any payout can also impact whether a Section 338(h)(10) election can be made.

If the business is to become part of a consolidated tax group, the seller should determine if any applicable tax sharing agreement will have an adverse effect on achieving any threshold.

Contingent Value Rights

Contingent value rights (CVRs) represent a version of an earn-out in transactions involving publicly traded companies. CVRs are particularly common in the pharmaceutical industry. As compared to traditional earn-outs, CVRs are usually of shorter duration and tied to the objectively verifiable outcome of a specific event, e.g., FDA approval of a drug.

A CVR can be deemed a security under applicable U.S. securities laws, subjecting the CVR to the registration requirements of the Securities Act at the time of closing. SEC no-action letters set out five essential factors that are needed for a CVR not to be considered a security:

  1. the CVR is an integral part of the consideration to be received in a transaction,
  2. the CVR is not represented by any form of certificate or instrument (usually not satisfied),
  3. the holder has no rights common to stockholders (e.g., voting and dividend rights) and the earn-out does not bear a stated interest rate,
  4. the CVR does not represent an equity or ownership interest in the buyer or the business, and
  5. the CVR is not assignable or transferable, except by operation of law.

Conclusions

Earn-outs:

  • can be an effective negotiating tool when there are differing perspectives on value and/or outlook for the business;
  • have benefits and risks to both parties that should be considered prior to inclusion as an element of the purchase price;
  • are difficult because they can be manipulated by whoever is running the business;
  • must be carefully drafted to minimize the potential for litigation;
  • recognize and address potential conflicting incentives in the agreement;
  • require specificity regarding thresholds and milestones and measurement methods; use examples whenever possible; and
  • require definition of a clear set of responsibilities and contractual protections.

Post-closing adjustment arbitration provisions can be enforceable, but they may not preclude litigation of all causes of action arising from the acquisition.


Appendix: Representative Delaware Cases

Chambers v. Genesee & Wyoming Inc., 2005 WL 2000765 (Del. Ch. Aug. 11, 2005) (Chambers)

  • The earn-out in connection with the acquisition of the business by the Buyer (Genesee & Wyoming, Inc.) provided for a payout if the business achieved $9 million of EBITDA (as defined in the agreement) in any of the five years 1999–2003. Following the acquisition, the Buyer’s publicly reported EBITDA exceeded the threshold in four of the five years. The Buyer, however, claimed that EBITDA (as defined in the agreement) had not exceeded $9 million in any year and that the earn-out had not been earned.
  • The discrepancy arose because the Buyer adjusted its publicly reported EBITDA to reflect vested options, and those adjustments lowered the EBITDA of the business. Noting that “EBITDA…can be a slippery concept,” the Court focused on “the plain language of the contract itself” and noted that while the adjustments might have been appropriate under GAAP, the agreement specifically excluded them for the purposes of the earn-out. Moreover, the agreement did not permit the Buyer to expense certain labor costs (for purposes of the earn-out) that it had capitalized for its public financial statements. The Court therefore concluded that the Buyer’s calculation of EBITDA was flawed

William J. LaPoint v. AmerisourceBergen Corp., 2007 WL 2565709 (Del. Ch. Sept. 4, 2007), aff’d, 956 A.2d 642 (Del 2008) (LaPoint).

  • Under the agreement, up to $55 million was contingent upon the business meeting certain EBITA targets in 2003 and 2004. The agreement provided that the Buyer (AmerisourceBergen Corp.) would “exclusively and actively promote the [business],” would act “in good faith” during the earn-out period and would not do anything to impede the ability of the Seller (William J. LaPoint, as stockholder representative) to receive the payout. The Court called such terms “aspirational statements…and gossamer definitions…too fragile to prevent the parties from devolving into the present dispute.”
  • In his suit, the Seller alleged that the Buyer had not “exclusively and actively” promoted the business’s products and that the Buyer had turned down a proposal for a marketing relationship that would have been very favorable to the Seller under the earn-out.
  • Despite accepting the Seller’s allegation that the Buyer had failed to promote the business, the Court held that there was no evidence that the Buyer’s failure had made a difference insofar as the market was moving away from the type of product made by the Business. Thus, damages were awarded in the amount of six cents. The Court also held that the buyer was not obliged to enter into the marketing agreement.
  • The Seller fared better on the claim the earn-out calculation was in error. Among other things, the Court held that the Buyer could not adjust EBITA downward to account for incumbent management’s failure to invest in research and development as was required by the agreement. The Court noted the Buyer would have “done well to have included in the…agreement” an appropriate EBITA adjustment, but it declined to draft “any such clause into the agreement ex post.”
  • Under the agreement, sales to certain customers were to be discounted by an average discount (based on the last five contracts entered into before the execution of the agreement) in determining an adjustment to EBITA for earn-out purposes. The Buyer argued that the determination of average discount should be based on a weighted (by transaction size) average, which would have the effect of lowering EBITA. The Court rejected the argument because “the most straightforward usage of the term ‘average’ is an arithmetic mean.”
  • Overall, the Court characterized the Buyer’s arguments as “invok[ing] the agreement that it wishes it had signed, rather than the agreement that it drafted.” The cumulative changes resulted in an upward adjustment to the business’s EBITA of $6.2 million and a payout of $21 million, 44 percent of the total transaction price.

Airborne Health, Inc. v. Squid Soap, LP, 984 A.2d 126 (Del. Ch. 2009) (Airborne Health)

  • Because the Buyer (Airborne Health, Inc.) and the seller (Squid Soap, LP) were unable to agree on the value of the business, the agreement provided for a cash payment of $1 million at closing, “plus the potential for…[payouts] of up to $26.5 million if certain targets were achieved.” Although the agreement provided that the Buyer would return the business to the Seller if the Buyer did not meet certain targets, such as advertising spend and sales volume, the agreement did not contain “any specific commitments by [the Buyer] regarding the level of efforts or resources that it would devote” to the marketing and sale of the business’s products.
  • Owing, in part, to significant litigation filed against the Buyer prior to the closing of the agreement that had not been disclosed to the Seller, the targets were not met and the Seller sued the Buyer for fraud and breach of the implied covenant. Owing to the specific wording of the Buyer’s representations in the agreement, the Court dismissed the claims for fraud.
  • The Court did agree with the Seller that “[w]hen a contract confers discretion on one party, the implied covenant requires that the discretion be used reasonably and in good faith” and that “[the Buyer] could not arbitrarily refuse to expend resources and thereby deprive [the Seller] of the prospects for the earn-out.” However, the Court recognized that the Buyer had suffered a “corporate crisis” and “was [u]ndoubtedly restrained by…legal and financial burdens” and that such a scenario did not support a claim that the buyer exercised its contractual discretion in bad faith.

Comet Systems, Inc. v. Miva, Inc., 980 A.2d 1024 (Del. Ch. 2008) (Comet Systems)

  • In calculating the earn-out, the Buyer (Miva, Inc.) treated bonus payments as an operating expense rather than a “one-time, non-recurring expense,” which was to be excluded from the calculation of “profit per user.” As a result, the profit per user target under the earn-out was not met and the payout was reduced significantly. The agreement did not specifically define the intended meaning of “one-time, non-recurring expense.” The Court concluded that the bonus payments qualified as a “one-time, non-recurring expense” pursuant to the “plain, unambiguous meaning of the agreement.” The Court observed that “charges and costs which occur as a result of the [acquisition] and are not expected to be representative of future costs in the business are reasonably excluded. The natural reading of ‘one-time, non-recurring expenses’ is to exclude exactly such charges.”

Winshall v. Viacom International Inc., 55 A.3D (del. Ch. Nov. 10, 2011), aff’d 72 A.3d 78 (Del. 2013) (Winshall I)

  • In 2006, the Buyer (Viacom International, Inc.) acquired the business (Harmonix Music Systems, Inc.) for $175 million in cash and contingent uncapped earn-out payments based on the financial performance of the business in 2007 and 2008.
  • Winshall (as Seller’s representative) challenged the Buyer’s earn-out calculation, and the dispute was put to a designated neutral accountant. Although it was not identified in its original calculation, the Buyer argued to the neutral accountant it should be allowed to deduct, or, in the alternative, take a write-down for, the cost of the business’s unsold inventory (the “inventory issue”). In its decision, the neutral accountant rejected the inventory issue because the Buyer had not identified it, as required by the agreement, in its initial calculation and the Seller did not agree to have it resolved by the neutral accountant.
  • The Buyer filed a complaint with the Court, seeking a declaration vacating the neutral accountant’s determination on the grounds that it constituted “manifest error.” The Court disagreed and granted Winshall’s motion for summary judgment.
  • On appeal, the Buyer argued, among other things, that (i) the neutral accountant’s refusal to consider evidence of the inventory issue amounted to misconduct and (ii) the inventory issue was one of substantive arbitrability, which should have been decided by a court. The DSC disagreed and concluded that (a) the neutral accountant’s refusal to consider the inventory issue without the consent of the Seller was appropriate and (b) the Inventory Issue was one of procedural arbitrability, properly decided by the neutral accountant.

Winshall v. Viacom International Inc., 2012 WL 3249620 (Del. Ch. Aug. 9, 2012), aff’d 76 A.3d 808 (Del. 2013) (Winshall II)

  • The representative of the Sellers (Winshall) claimed that the Buyer deliberately failed to renegotiate certain distribution fees in order to reduce the Seller’s payout. Given that the agreement did not obligate the Buyer to renegotiate the fees, the Court rejected the Seller’s argument that the implied covenant implicitly obligated the Buyer to avoid manipulating the cost structure of the business to lower the payout.
  • The DSC upheld, among other things, the Court’s rejection of the Seller’s claim, noting that “the implied covenant is not a license to rewrite contractual language just because the plaintiff failed to negotiate for protections that, in hindsight, would have made the contract a better deal.”

American Capital Acquisition Partners v. LPL Holdings, 2014 WL 354496 (Del. Ch. Feb. 3, 2014) (LPL Holdings)

  • The agreement provided for a payout based on the achievement of certain “gross margin” thresholds. The agreement, however, did not include any provision requiring the Buyer (LPL Holdings) to make, or to use any efforts to make, certain technical adaptations to its computer systems necessary to allow the business to expand and eventually meet those thresholds.
  • The Seller (American Capital Acquisition Partners) argued that the existence of contingent price provisions obligated the Buyer to make those adaptations under the implied covenant. The Court pointed out in its opinion that although the parties anticipated that the Buyer’s systems would require some changes, they did not include any provision in the agreement obligating the Buyer to make any technical adaptations necessary to allow the further development of the Business. The Court reiterated that the implied covenant serves only a gap-filling function that is only relevant when an issue arises ex post that was not anticipated when the contract was negotiated. Here, the Seller “anticipated, but failed to bargain for, a requirement that [the Buyer] adapt [its] software and data-handling capabilities.”
  • At the same time, the Court did find that the Buyer breached the implied covenant by allegedly diverting the Seller’s clients and employees to another subsidiary of the Buyer and discouraging clients and prospective clients from using the Seller’s resources.

Lazard Technology Partners, LLC v. Qinetiq North America Operations LLC, 114 A.3d 193 (Del. 2015) (Lazard Technology)

  • The Buyer (Qinetiq North America Operations LLC) paid the Seller (Lazard Technology Partners, LLC, as stockholder representative) $40 million for the business, plus a potential earn-out of $40 million if the business reached certain revenue levels. The agreement prohibited the Buyer from taking “any action to divert or defer [revenue] with the intent of reducing or limiting the…[Payout].” When the business did not reach the requisite target, the Seller sued the Buyer for violating the contractual prohibition and the implied covenant.
  • After trial, the Court held that the Seller failed to prove that the Buyer acted with the requisite intent to violate the agreement. Owing to the existence of the express covenant not to take action “with the intent of reducing or limiting the…[payout],” there was not an implied covenant inconsistent with that express covenant.
  • The DSC upheld the lower court’s bench ruling. According to the DSC, the plaintiff had the burden to establish that the Buyer’s action was “specifically motivated by a desire to avoid the earn-out.” In that regard, the plain language of the agreement limited the Buyer’s actions only if they were done with the motivation to avoid the earn-out. Furthermore, because the agreement specifically set forth the standard for the Buyer’s behavior, the Seller’s argument was without merit.

Fortis Advisors LLC v. Dialog Semiconductor PLC, 2015 WL 401371 (Del. Ch. Jan. 30, 2015) (Dialog Semiconductor)

  • The Buyer (Dialog Semiconductor PLC) was required to “use commercially reasonable best efforts” in managing the business to achieve the earn-out. The agreement also included specific obligations and prohibitions on the Buyer’s operation of the business.
  • When the business failed to achieve the earn-out threshold, the Seller (through Fortis Advisors) brought suit alleging, among other things, breach of contract and, in the alternative, breach of the implied covenant.
  • As the agreement expressly obligated the Buyer to use commercially reasonable best efforts and explicitly restricted the Buyer from taking certain actions, the Court rejected the assertion that the implied covenant could be used as an alternative theory to contractual breach with respect to the earn-out provision in dispute.

Haney v. Blackhawk Network Holdings Inc., 2016 WL 769595 (Del. Ch. Feb. 26, 2016) (Haney)

  • The Seller (Haney) sued for, among other things, breach of the implied covenant when the business failed to reach an earn-out target. The Seller alleged that the Buyer (Blackhawk Network Holdings Inc.) deliberately prevented the business from achieving the Target by failing to devote required resources to the business.
  • The Seller argued that the agreement’s requirement that the Buyer’s “key personnel…dedicate a commercially reasonable” amount of time and resources to the generation of revenue did not specifically provide a standard for evaluating the conduct of the Buyer’s personnel. (The argument was intended to distinguish from Dialog Semiconductor where the Court held that an agreement’s “best efforts” standard and specified Buyer obligations barred applying the implied covenant.)
  • The Court disagreed, finding that the express terms of the agreement controlled, and dismissed the Seller’s claim. The Court, however, did find that the Seller’s allegation that the Buyer failed to disclose an exclusivity provision in a key contract (which precluded the achievement of the relevant target) stated a claim for unjust enrichment based on fraud.

Zhu v. Boston Scientific Corp., 2016 WL 1039487 (D. Del. Mar. 15, 2016) (Boston Scientific)

  • A federal court applying Delaware law concluded that the failure to develop a medical technology in a manner that would have allowed the Seller (Zhu) to receive a payout did not constitute a breach of the implied covenant. The Court concluded that the Sellers “simply disagree with how [the Buyer (Boston Scientific Corp.)] chose to develop the [t]echnology” and that commercially reasonable conduct does not rise to the level of a breach of good faith.

Sharma v. TriZetto Corp., 2016 WL 1238709 (D. Del. March 29, 2016) (TriZetto)

  • The Seller (Sharma) sold the business to the Buyer (TriZetto Corp.) for $13.5 million in cash plus additional consideration in an earn-out if the Business achieved gross revenues of $47.2 million in the 2013 calendar year.
  • The parties anticipated that the Buyer would engage in subsequent acquisitions, and the agreement provided that the parties would negotiate in good faith to determine whether revenue from such acquisitions would apply toward the earn-out revenue goal. As a default, until the parties agreed otherwise, the revenue from those acquisitions would not be applied against the goal.
  • After objecting to the payout calculation, the Seller sued claiming that the Buyer breached the agreement by operating the business to avoid owing the payout, by failing to include post-closing acquisitions in the payout calculation, by failing to engage in good-faith negotiations or provide reasonable details concerning the earn-out calculations, by failing to appoint a neutral accountant to resolve the dispute between the parties, and by failing to maintain and promote the business.
  • The District Court (applying Delaware law) dismissed the claim for breach of contract, holding that the Seller had failed to allege facts that suggested that the Buyer made its decisions to avoid the earn-out payment. Because the agreement did not require the Buyer to make any specific disclosures in connection with the earn-out calculation statement, and because the parties had over ten months of discussions concerning the earn-out calculation, the Court held the plaintiffs had not alleged sufficient facts to support a claim that they failed to engage in good faith negotiations or to supply reasonable detail regarding its calculation. Because the dispute concerned which of the acquired businesses were part of the business, the issue was deemed outside the purview of the neutral accountant. Lastly, the Court held that the alleged facts did not fall into a “gap” in the agreement that would require the operation of the implied covenant.

Shareholder Representative Services LLC v. Gilead Sciences Inc. et al., 2017 WL 101561 (Del. Ch. Mar. 15, 2017), aff’d 177 A.3d 610 (Del. 2017) (Gilead Sciences)

  • The Buyer (Gilead Sciences Inc.) purchased the business for $375 million plus a series of three milestone payments if the business’s principal cancer drug obtained certain regulatory approvals, two of which were obtained.
  • The third $50 million payout was due upon regulatory approval of the drug in the United States or European Union as a “first-line drug treatment…for a Hematologic Cancer Indication.” When the drug was approved by the European Union as a first-line treatment for patients with chronic lymphocytic leukemia, but only those with a specified genetic mutation, the parties disputed whether the final milestone had been met.
  • Finding that the use of the word “indication” to describe the milestone was ambiguous, the Court reviewed the extrinsic evidence to determine that when the parties entered into the agreement, they mutually understood that the term “indication” meant “a disease.” Because the drug had been approved only for a specific subset of patients having leukemia, rather than having been approved as a first-line treatment of the disease called leukemia, the Court determined that the requisite milestone had not been achieved.

Shareholder Representative Services v. Valeant Pharmaceuticals, C.A. No. 12868-VCL (Del Ch. 2017) (Valeant)

  • The Seller (Sprout Pharmaceuticals), which had developed a “female Viagra” drug (Addyi), entered into an agreement that required the Buyer (Valeant Pharmaceuticals) to use “diligent efforts” to pursue the development and “commercialization” of Addyi.
  • The agreement had explicit definitions of the required post-closing “diligent efforts” required of the Buyer, specifying both general standards plus four specific requirements on matters like minimum spending and staffing.
  • The Seller’s representative alleged that the Buyer’s high pricing of Addyi, while not contrary to any of the requirements of the agreement, violated the implied covenant by being unreasonable and therefore causing sales to be lower than anticipated.
  • Notwithstanding that the agreement covered “commercialization” of Addyi, the Court held that it could not dismiss an argument that “pricing” was separate from “commercialization,” and, therefore, there was a gap that could be filled by the implied covenant. The Court made a similar finding about the Buyer’s decision to sell Addyi through a pharmacy channel that was under criminal investigation.

Fortis Advisors LLC v. Shire US Holdings, Inc., 2017 WL 3420751 (Del. Ch. Aug. 9, 2017) (Shire)

  • The Seller’s representative (Fortis Advisors LLC) sought the payment of two milestone payouts totaling $425 million. The first milestone required the occurrence of an “achievement date,” which was defined in the agreement as satisfaction of certain efficacy endpoints in a study of a drug for dry eye disease (the “Study”). The second milestone was payable upon receipt of regulatory approval for the drug, contingent on the prior occurrence of the achievement date milestone.
  • The drug did not meet the required Study endpoints by the achievement date. However, the Buyer (Shire US Holdings, Inc.) continued development of the drug, which ultimately gained regulatory approval using the results of the Study as well as clinical data from other studies conducted prior to the Study (the “Prior Studies”).
  • The Sellers argued that the agreement should be interpreted as allowing consideration of the Prior Studies, not just the Study, in determining whether the endpoints had been achieved for purposes of determining whether the achievement date had occurred.
  • The Court held that since the “achievement date” was defined by reference to the outcome of a specific Study, the first milestone was not met because the endpoints of that Study were not met.
  • The Court rejected the Sellers’ argument that the first milestone did not expressly exclude consideration of other studies, and, therefore, the results of the Prior Studies could be included, noting that the agreement specifically referenced the Study and did not reference the results of other clinical studies.
  • The Court also found that since the second regulatory approval milestone was contingent on the occurrence of the achievement date, which was not met, the regulatory approval milestone was also not met.

GreenStar IH Rep., LLC v. Tutor Perini Corp., 2017 WL 5035567 (Del. Ch. Oct. 31, 2017) (Tutor Perini)

  • The agreement pursuant to which the Buyer (Tutor Perini Corp.) bought the business provided for the Seller (GreenStar Services Corp.) to receive payouts over five one-year terms. For each term, the Seller was entitled to a payout equal to 25 percent of the business’s pre-tax profit in excess of $17.5 million, up to a cap of $8 million. Any excess amounts (a surplus) that would have been paid but for the cap were to be applied to any ensuing payouts falling short of the cap.
  • The agreement required the Buyer to calculate pre-tax profit and provide the calculation to the Seller’s shareholder representative. If the representative accepted the calculation or did not object to it within 30 days, the Buyer was obligated to pay the payout it had calculated. If there was an objection to the calculation, the parties were required to try to resolve the dispute and, failing a resolution, to submit the matter to arbitration by a neutral accountant.
  • After making the first two annual payouts (capped in each case at $8 million, with $9.2 million surplus available to use in future years), the Buyer claimed that it had come to suspect that incumbent management had supplied false information to raise the reported profits of the business. Although the Buyer calculated pre-tax profits for the third and fourth years (which were materially lower than the first two years and were not objected to by the Seller’s representative), it did not make the required payout to the Seller (despite the $9.2 million Surplus from the first two years). In the fifth year, the Buyer neither calculated the pre-tax profit nor made a Payout.
  • As a counterclaim to the Seller’s suit for the unpaid payouts, the Buyer asked the Court to rule, among other things, that it was not obligated to make the payouts for the third, fourth, and fifth year due to the fraudulently inflated pre-tax profit numbers.
  • The Court rejected the counterclaim, holding that the agreement did not permit the Buyer to withhold payouts if it doubted the accuracy of the information that was used to calculate pre-tax profit. The agreement only provided a dispute resolution mechanism under which if the Seller objected to the Buyer’s earn-out calculation, there would be binding arbitration. As the Seller had not objected to the calculations, the Court ordered the Buyer to make $20 million in payouts for the third, fourth, and fifth years. The Court noted that the Buyer could have negotiated for the right to withhold a payout if it doubted the accuracy of the information on which it was calculating the pre-tax profit of the Business.
  • In a subsequent proceeding (GreenStar IH rep, LLC, et al. v. Tutor Perini Corp., C.A. No. 12885-VCS, memo op. (Del. Ch. Dec. 4, 2019), or Tutor Perini II), the Court addressed an escrow release agreement that the parties had entered into that provided for payouts to the Seller only if certain accounts receivable were collected. In adjudicating whether the condition had been satisfied, the Court found that the agreement, though not a model of clarity, was unambiguous when read together with an incorporated exhibit illustrating its operation and when “read in full and situated in the commercial context between the parties.”

Exelon Generation Acquisitions, LLC v. Deere & Co., 176 A.3d 1262 (Del. 2017) (Exelon Generation)

  • The Buyer (Exelon Generation) agreed to make payouts to the Seller (Deere & Co.) if certain milestones were reached in the development of three wind farm projects that were underway at the time of sale. One of the projects became impossible to develop due to local ordinances that were passed. An issue arose as to whether the development by the Buyer of another wind farm 100 miles away, that was not referenced in the agreement, could satisfy one of the milestones that would trigger the payout.
  • The DSC reversed the Delaware Superior Court and rejected the earn-out claim based on the application of contract interpretation principles. Specifically, the DSC noted that if a contract is unambiguous, extrinsic evidence may not be used to interpret the intent of the parties, to vary the terms of the contract, or to create an ambiguity. In addition, in interpreting an earn-out provision, the parties’ post-closing conduct may be used to determine whether there is a breach, but post-closing evidence cannot be used as an aid to interpreting the meaning of the contract when the contract is unambiguous.

Edinburgh Holdings, Inc. v. Education Affiliates, Inc., 2018 WL 2727542 (Del. Ch. June 6, 2018) (Edinburgh Holdings)

  • The agreement pursuant to which the business was sold provided for four annual contingent payouts based upon the revenue of the business, which was to be managed by the incumbent management “in a reasonable manner and consistent with the past practices of the Seller (Edinburgh Holdings, Inc.).”
  • After making three payouts, the Buyer refused to make the fourth and the Seller sued to obtain the payout. The Buyer sought dismissal on the basis that the business had not been operated by the incumbent management “consistent with past practices.”
  • The Court refused to grant the Buyer’s motion to dismiss because the issue of whether the business was operated consistent with past practices was fact-intensive and therefore could not be decided at the pleading stage.
  • The Court also ruled that the Seller’s implied covenant claim was inapplicable because the agreement expressly set forth a standard for operation of the business during the earn-out period. The Court further noted that a claim for breach of the implied covenant can be maintained only if the factual allegations underlying the claim differ from those underlying an accompanying breach of contract claim.

Fortis Advisors LLC v. Stora Enso AB, 2018 WL 3814929 (Del. Ch. Aug. 10, 2018) (Stora Enso)

  • The Seller’s representative (Fortis Advisors LLC) alleged that two payouts were owed to it based on the achievement of two milestones, the first of which required the construction of a plant and the completion of the production of certain other products, and the second of which required the construction of a separate plant and the production of certain products at a specific price by a specific deadline. The claim for breach of contract alleged that the Buyer (Stora Enso AB) did not comply with the business plan that was part of the agreement and failed to take the actions required to be taken for the payouts to be due.
  • The Court observed that in a motion to dismiss, the movant can only prevail if its proffered interpretation of the agreement is the only reasonable interpretation. Here, the interpretations of the agreement by each of the parties were both reasonable, and, therefore, as a procedural matter, the Court found that granting the Buyer’s motion to dismiss was inappropriate.

Himawan v. Cephalon, Inc., 2018 WL 6822708 (Del. Ch. Dec. 28, 2018) (Cephalon)

  • Four hundred million dollars in payouts were contingent on the continued development and commercialization by the Buyer (Cephalon, Inc.) of a particular antibody, with $200 million being payable upon regulatory approval of the antibody for each of two medical conditions.
  • The agreement required the Buyer to use “commercially reasonable efforts” to develop the antibody and achieve the milestones, with “commercially reasonable efforts” defined as “the exercise of such efforts and commitment of such resources by a company with substantially the same resources and expertise as [the Buyer], with due regard to the nature of efforts and cost required for the undertaking at stake.”
  • The Buyer received relevant regulatory approval for one of the identified conditions and paid the Seller $200 million. The Buyer, however, abandoned development and commercialization of the antibody for the second identified condition, foreclosing the possibility of the second $200 million payout and prompting a lawsuit by the Seller (Himawan) for breach of contract.
  • In denying a motion to dismiss, the Court focused on the requirement that the Buyer expend efforts that companies with substantially the same resources and expertise would expend in the circumstances at hand and noted that it was unclear what additional obligations, if any, were imposed upon the Buyer by such language. Because the Sellers alleged that the Buyer abandoned efforts toward the second milestone while companies with similar resources and expertise continued to pursue them, the Court found dismissal inappropriate.

Glidepath Ltd. v. Beumer Corp., 2018 WL 2670724 (Del. Ch. Feb. 21, 2019) (Glidepath)

  • The Buyer (Beumer Corp.) acquired 60 percent of Seller (Glidepath Ltd.) upfront, with the remaining 40 percent to be acquired three years later at a price dependent upon the future performance of the business.
  • The agreement stated that the earn-out period covered “fiscal years 2014, 2015 and 2016.” Although the parties expected to sign the agreement shortly before the commencement of the Seller’s fiscal 2014 year, the signing and closing did not take place until several months later. Notwithstanding the change in signing date, the specified earn-out period remained unchanged.
  • During the period of the Seller’s minority ownership, the Buyer (which had primary control over the venture) reoriented the business towards longer-term projects and invested in training personnel, which depressed the short-term profits of the business.
  • When it became apparent that the Seller would not be entitled to much, if any, of the earn-out, the Seller sued for, among other things, breach of fiduciary duty, contending that the Buyer “disloyally engag[ed] in a scheme to depress revenues, increase expenses and divert business opportunities for their own benefit.”
  • Though finding that the Buyer owed fiduciary duties as a manager and controlling shareholder, the Court held that, because Delaware LLCs exist perpetually, the default duty must be to “maximize the value of the LLC over a long-term horizon,” rather than maximizing the value of a beneficiary’s contractual claim against the Buyer.
  • Although there was no breach of fiduciary duty, the deal structure did create a conflict of interest that was subject to entire fairness review. However, the Court found that focusing on large-scale projects was a valid business strategy and promoted the value of the LLC. According, the Buyer’s conduct was found to be entirely fair even though it did not maximize the Seller’s contingent consideration.

Western Standard, LLC v. SourceHOV Holdings, Inc., 2019 WL 3322406 (Del. Ch. July 24, 2019) (Western Standard)

  • Pursuant to the agreement by which the Buyer (SourceHOV Holdings, Inc.) acquired the business, the Sellers (represented by Western Standard LLC) were entitled to a payout if a “realization event” occurred within seven years of closing. During the earn-out period, the Buyer undertook several merger transactions, which resulted in a demand from the Sellers to receive the payout, as they interpreted the transactions to all be within the scope of the definition of a realization event. The Buyer moved to dismiss, arguing that the agreement stated that mergers of the type undertaken by the Buyer would not be considered a realization event.
  • The Court confessed that it was “unable to divine any meaning from the contract” and found that neither party provided an interpretation of realization event that made sense; therefore, the Court denied the motion to dismiss to allow the parties to present extrinsic evidence that would allow the Court to discern the meaning of the relevant provisions of the agreement.

Windy City Investments Holdings, LLC v. Teachers’ Insurance and Annuity Assoc. of America, C.A. No. 2018-0419-MTZ (Del. Ch. July 26, 2019) (Windy City)

  • The Buyer (Teachers’ Insurance) acquired the business (Nuveen, Inc.) from the Seller (Windy City Investments) for $6.25 billion, plus an earn-out based on the profitability of the business of between $45 million (if the specified floor targets were met) and $278 million (if the specified target caps were met). The earn-out was based on the “cumulative advisory revenues” and net flows of the business during the four-year earn-out period. The floor and cap targets were to be adjusted (upward or downward, respectively) “in the event of acquisitions or dispositions” of investment accounts from non-[Buyer] affiliated parties. The agreement also provided that the Seller would receive the maximum payout if the business was sold.
  • Cumulative advisory revenues included 50 percent of revenues derived from investment accounts advised by the Buyer and excluded advisory revenues derived from the Buyer’s general investment accounts. Net flows were to be based on increases in assets under management by the business less withdrawals, and they included 50 percent of third-party accounts advised by the Buyer and excluded general assets of the Buyer.
  • Among other things, the agreement provided that the Buyer would not take “any action the intent of which is to reduce the [payout]” and that the Seller would have “reasonable access to relevant personnel (including accountants), work papers, and books and records related to the [Business]”. Disputes with respect to the earn-out were to be submitted to a neutral accountant for resolution; however, the parties were obligated to seek judicial interpretation of any disputed contract terms, with the neutral accountant being bound by such interpretation in making its calculations.
  • A dispute arose as to how revenues and flows from investment products advised or managed solely by the Buyer, but distributed through the business, were to be treated. The Seller believed it was entitled to 50 percent credit for any gains from such products, whereas the Buyer believed the Seller was only entitled to credit for gains from investment products with respect to which the business was the advisor.
  • In a subsequent suit, the Court rejected the Buyer’s motion to dismiss, finding that “[n]either party provide[d] the only reasonable interpretation” of the disputed language and that the parties’ respective interpretations “require[d] the Court to minimize deliberately placed language or, in some cases, import extra-contractual concepts to reconcile that language.”
  • The Court also refused to dismiss the Seller’s claims (i) that the Buyer breached the agreement in connection with the sale of certain businesses in a manner intended to depress the Seller’s payout and (ii) for access to the books and records of the business.

Collab9, LLC v. En Pointe Technologies Sales, LLC, C.A. No. N16C-12-032 MMJ CCLD (Del. Super. Sept. 17, 2019) (En Pointe)

  • The Buyer (En Pointe Technologies) acquired substantially all of the assets of the business from the Seller (Collab9 LLC) pursuant to an agreement which provided for payout calculated as a percentage of the business’s adjusted gross profit over several years.
  • The agreement provided that the Buyer would have “sole discretion with regard to all matters relating to the operation of the business” and would have no obligation, express or implied, to take any action, or omit to take any action, to maximize the payout.
  • The Seller brought suit for breach of contract, for breach of the implied covenant, and for fraud based upon alleged inaccuracies in the Buyer’s quarterly earn-out certifications.
  • The Court dismissed the claims for breach of the implied covenant and for fraud. Given the agreement’s “comprehensive and explicit” language controlling the obligations of the parties with respect to operating the business post closing, there was no place for the gap-filling role of the implied covenant under the circumstances. The Court found that the Seller’s fraud claim, based upon the Buyer’s alleged failure to respect duties under the agreement, amounted to a deficient “repackaging” or “bootstrapping” to its breach of contract claim.

Fortis Advisors LLC v. Allergan W.C. Holding Inc., C.A. No. 2019-0159-MTZ (Del. CH. Oct. 30, 2019) (Allergan)

  • The Buyer (Allergan) paid $125 million at closing and contracted for payments of up to $300 million upon certain milestones for a device for the treatment of dry-eye disease (the Device). The first milestone was achieved, and the Buyer paid $100 million to the Seller.
  • The second $100 milestone required FDA authorization of the Device’s use for “the treatment of at least one Dry Eye Disease Symptom (the “Labeling Milestone”).” The agreement required the Buyer to use “commercially reasonable efforts” to achieve the Labeling Milestone. “Commercially reasonable” was further defined to include “expending resources that [the] Buyer would typically devote to…products of similar market potential at a similar stage of development.”
  • The FDA approved a label for the Device that indicated that the product “provides a temporary increase in tear production…to improve dry eye symptoms in adult patients with severe dry eye symptoms.” In turn, the Buyer claimed the Labeling Milestone was not achieved because the FDA approval did not include “treatment” or “disease” and because the increase in tear production was “temporary.”
  • The Seller (Fortis Advisors, as representative) brought suit alleging breach of the agreement due to the Buyer’s refusal to make the second milestone payment and for its failure to use “commercially reasonable efforts” to achieve the Labeling Milestone.
  • The Court rejected the Buyer’s motion to dismiss, concluding that the FDA approval of an indication for use of the product “to improve dry eye symptoms” satisfied the Labeling Milestone requirement of “treatment of dry eye symptoms.” The Court also concluded that the indication of “temporary” did not preclude satisfaction of the Labeling Milestone. Moreover, the indication for “severe” dry eye symptoms did not matter because the Labeling Milestone did not specify a specific patient population to be addressed by the device.
  • The Court also credited the Seller’s allegation that the Buyer waited two years before applying to the FDA for a label for the Device and then waited four months to reapply when the FDA rejected the Buyer’s first labeling application. The Court determined that the allegations supported a reasonable inference that the Buyer’s efforts “fell short of its comparable efforts for other similar products,” as required by the agreement.

MarkDutchCo 1 B.V. v. Zeta Interactive Corp., C.A. No. 17-1420-CFC (D. Del. Nov. 12, 2019) (MarkDutchCo)

  • The Seller (MarkDutchCo) sold its interest in the business (customer relation management) to the Buyer (Zeta Interactive Corp.) for $23 million in cash, shares of Zeta common stock, and several earn-out payments, the first of which required a payout of $4 million if the business’s EBITDA was at least $10 million during the 12-month earn-out period following closing. The agreement required the Buyer to deliver to the Seller a statement detailing the Buyer’s determination of EBITDA for the relevant period and its calculation of the associated payout. The agreement gave the Seller the right to “review all [the] materials and information” the Buyer used to prepare the calculation. The Seller could dispute the Buyer’s calculation by providing a written objection notice within ten business days, setting forth “in reasonable detail [its] alternative calculations (if any), together with reasonable supporting details.”
  • The Seller sent an objection notice disputing the entirety of the Buyer’s calculation but did not include an alternative EBITDA calculation because it lacked sufficient information. The Buyer claimed the notice was therefore invalid and its calculation was final and binding. After receiving more information, the Seller sent a supplement to its objection and calculated an EBITDA for the business that was significantly higher than the $10 million target. The Seller also submitted the dispute to a neutral accountant, who was to be “the sole arbiter of all matters, procedural and/or substantive, as to such Disputed Payment Amount.” The neutral accountant’s determination was to be final and binding absent “fraud, bad faith or manifest error.” Ultimately, the neutral accountant found the EBITDA to be in excess of the target, and the Seller sued for confirmation of the $4 million payout under the FAA.
  • In its counterclaim, the Buyer alleged that the Seller misrepresented the validity of certain patents and that such misrepresentations were fraudulent and constituted a breach of the representations in the agreement, entitling the Buyer to without the payout. The Buyer also alleged, among other things, that the neutral accountant exceeded his scope of powers by considering the Seller’s supplement. The District Court (applying Delaware law) disagreed, finding that because the Seller was only required to provide an alternative calculation “to the extent possible based on the information available to [it],” the neutral accountant was within the scope of his powers in accepting the supplement following receipt of the required information from the Buyer.
  • In affirming the neutral accountant’s award, the Court also rejected the Buyer’s counterclaims and indemnity offsets as being outside the ambit of the arbitration confirmation proceeding or as being time barred.

Merrit Quaram v. Mitchell International, Inc., 2020 WL 351291 (Del. Super. Ct. Jan. 21, 2020) (Quaram)

  • The Buyer (Mitchell International, Inc.) bought a business from the Seller (Quaram) that developed review and approval processes from reimbursement and insurance claims. The Buyer and the Seller entered into an earn-out agreement that allowed the Seller to earn additional compensation for two years after the sale. Pursuant to the agreement, the Buyer had “the power to direct the management, strategy and decisions” of the business post closing. However, the Buyer also agreed that it would “act in good faith and in a commercially reasonable manner to avoid taking actions that would reasonably be expected to materially reduce the earnout.” The Buyer also agreed to “act in good faith and use commercially reasonable efforts to present and promote” the acquired company’s products “to customers that could reasonably be expected to utilize them.” Lastly, the Buyer agreed to upgrade or build a bridge between the Buyer’s existing systems and those of the acquired business within six months of closing so as to allow the Buyer to sell the acquired company’s products to its existing customers and to assist in calculating the earn-out.
  • The Seller entered into a two-year employment agreement with the Buyer to assist with the post-closing marketing and business. After the Seller was terminated by the Buyer, the Seller brought suit alleging breach of the earn-out covenants. The Superior Court denied the Buyer’s motion to dismiss certain of the Seller’s allegations.
  • The Court viewed the first earn-out covenant as one requiring the Buyer to refrain from positive actions that reasonably could be expected to reduce the earnout or impede calculating the earnout. In that regard, the Court indicated that the covenant’s obligation did not extend to “avoiding inaction,” inasmuch as to do so would give the Seller the “power to manage the company.” Examples of such inaction related to “decisions and strategies [the Buyer] could have pursued but did not,” such as consulting with the Seller on marketing.
  • The claims that survived the motion to dismiss focused on positive actions, such as “routinely cancel[ing] regularly scheduled calls to prevent [the Seller] from promoting and selling” the products, making improper accounting decisions concerning minimum thresholds for bills, and diverting revenue to different products to avoid paying the earn-out.
  • With respect to the third provision of the earn-out agreement, the Buyer argued that the Seller could not plead damages resulting from the Buyer’s decision to build an alternative bridge between the parties’ systems. The Court, however, found that it was reasonable to infer from the agreement that a specific solution was necessary to provide services to customers and calculate the earn-out amount and that failing to build that solution could constitute damages.

Shareholder Representative Services LLC v. Albertsons Companies, Inc., 2021 WL 2311455 (Del. Ch. June 7, 2021)

  • The Sellers were the former stockholders in DineInFresh, Inc. (d/b/a Plated), an e-commerce subscription meal-kit delivery company (Plated) whose business model involved consumers subscribing to its services in exchange for ingredients and recipes for home-cooked meals being delivered to their homes. In September 2017, the Sellers and the Buyer entered into a merger agreement pursuant to which the Buyer acquired the Sellers for $175 million in cash and an earn-out of $125 million, payable over three years.
  • The merger agreement gave the Buyer the right to make all post-closing business and operational decisions “in its sole and absolute discretion” and expressly stated that it would have “no obligation to operate [Plated] in a manner to maximize achievement of the [earn-out].” However, that right was subject to a provision obligating the Buyer not to “take any action (or omit to take any actions) with the intent of decreasing or avoiding” payment of the earn-out.
  • In the litigation, the plaintiff, on behalf of the Sellers, contended that the earn-out was premised on Plated’s historical and projected performance and that the Buyer had repeatedly provided assurances throughout the merger negotiation that it would allow Plated to operate independently post acquisition and would support Plated’s efforts to increase meal-kit market share while gradually phasing in brick-and-mortar initiatives. Instead, immediately upon closing of the merger, the Buyer directed Plated to reallocate its resources to get a retail version of its product into 1,000 of the Buyer’s stores in the space of one week. In addition, the plaintiff alleged that the Buyer interfered with employment decisions and generally mismanaged the business, including by failing to take advantage of preferred pricing and financing opportunities. Thereafter, Plated missed its earn-out milestones and the Buyer did not make the earn-out payment to the Sellers.
  • The plaintiff alleged that Plated would have succeeded and at least a portion of the earn-out would have been paid but for Albertsons’s active interference with Plated’s business. The plaintiff asserted three causes of action: (i) breach of contract by acting with the intent of avoiding the earn-out, (ii) breach of the implied covenant, and (iii) fraudulent inducement.
  • The Court held that the plaintiff’s allegations were sufficient to support a reasonable inference that the Buyer breached the earn-out agreement inasmuch as those well-pleaded allegations suggested that the Buyer knew that changing Plated’s business model would cause the company to miss the earn-out milestones and that the Buyer’s actions were motivated at least in part by a desire to avoid the earn-out. The Court reasoned that even if the Buyer took its actions only in part with the purpose of causing Plated to miss the earn-out milestones, this was enough at the pleading stage to support the plaintiff’s breach of contract claim.
  • The Court dismissed the plaintiff’s implied covenant claim, finding that the merger agreement gave the Buyer the absolute discretion to run the business in good faith. Accordingly, there was no contractual gap to fill. The Court also rejected the plaintiff’s fraudulent inducement claim based on the Buyer’s alleged misrepresentations during the merger agreement negotiation. The Court found that such misrepresentations were future promises and statements of intent with respect to post closing operations and that the Sellers were not justified in relying on such misrepresentations.

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  1. Airborne Health, Inc. vs. Squid Soap LP, 984 A.2d 126 (Del. Ch. 2009).

  2. The average transaction value of the 151 target companies in the ABA Study was $207.8 million.

  3. Earn-outs made up 27 percent of the consideration in the (non-life sciences) transactions between the 2014–2018 review in SRS Acquiom’s 2019 M&A Deal Terms Study (the SRS Study).

  4. Unless otherwise specified, case citations and summaries are found in the appendix.

  5. Approximately 31 percent of the earn-out provisions in the ABA Study used EBITDA as the principal performance metric; 29 percent used revenue.

  6. In the ABA Study, 66 percent of the agreements contained such a provision, whereas 76 percent of the agreements in the SRS Study contained such a provision.

  7. Eighty percent of the agreements in the SRS Study had earn-out periods of 1–3 years. However, longer earn-out periods were present in Chambers (five years), Tutor Perini (five years), Edinburgh (four years), Western Standard (seven years), and Windy City (four years).

  8. Twenty-two percent of the agreements in the ABA Study and 21 percent of the agreements in the SRS Study contained such a provision.

  9. Found in 33 percent of the agreements in the ABA Study.

  10. Found in 15 percent of the agreements in the ABA Study.

  11. Found in 17 percent of agreements in the ABA Study and 14 percent of the agreements in the SRS Study.

  12. Found in ten percent of the agreements in the ABA Study and three percent of the agreements in the SRS Study.

By: Richard De Rose

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