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Earnouts – Seller Pitfalls And Risks

By Patrick A. Traber & Michael T. Cronin | Categories: Articles, Business, TaxPrint PDF April 2018

Earnouts are a traditional transaction structuring mechanism to help sellers and buyers of a company bridge valuation gaps. Earnouts are increasingly utilized in today’s current high valuation market. Earnouts help sellers maximize the value of their enterprise, while at the same time providing downside protection for buyers. However, earnouts are not without their pitfalls and risks for sellers.

Absent a contractual provision, a buyer does not have any duty to insure or maximize the earnout – but the buyer cannot purposely frustrate the earnout. In the absence of clear standards governing the buyer’s post-acquisition conduct set forth in the parties’ agreement, a seller would likely not prevail on a claim that the buyer violated an implied covenant of good faith so long as the buyer can establish that its actions were commercially reasonable.

For example, in Winshall v. Viacom International, Inc., 76 A.3d 808 (Del. 2013), the Delaware Supreme Court held that the implied covenant does not give the plaintiff contractual protections that it failed to secure for itself at the bargaining table. In Zhu v. Boston Scientific Corporation, No. 14-542-SLR, 2016 WL 1039487 (D. Del. Mar. 15, 2016), a federal district court applying Delaware law concluded that the buyer’s failure to develop a medical technology in a manner that would have allowed the sellers to receive earn-out payments did not constitute a breach of the implied covenant. The court concluded that sellers “simply disagreed with how [the buyers] chose to develop the [t]echnology,”and that commercially reasonable conduct does not rise to the level of a breach of good faith. The analysis is very fact specific; in contrast, in American Capital Acquisition Partners, LLC v. LPL Holdings, Inc., No. 8490-VCG, 2014 WL 354496 (Del. Ch. Feb. 3, 2014), the Delaware Chancery Court held that a selling shareholder’s claim for breach of the implied covenant of good faith was actionable because the parties had not contemplated that the defendants might affirmatively act to gut the seller’s business to minimize the earnout payments.

Even when there are provisions to protect a seller, those provisions must be crafted with precision. In Lazard Technology Partners, LLC v. Qinetiq North America Operations, LLC, 114 A.3d 193 (Del. 2015), the merger agreement prohibited the buyer from “taking any action to divert or defer revenue with the intent of reducing or limiting the [e]arn-[o]ut [p]ayment.” The Delaware Supreme Court placed the burden on the seller to establish that the buyer’s action was “specifically motivated by a desire to avoid the earn-out.” In GreenStar IH Rep, LLC v. Tutor Perini Corporation, 2017 WL 5035567 (Del. Ch. 2017), the Delaware Supreme Court held that the implied covenant of good faith and fair dealing did not apply because the agreement clearly reflected the parties’ intent to impose a definitive timeline within which the accuracy of a pre-tax profit could be challenged.

In light of the hesitancy of courts to impose an implied duty of good faith upon the buyer in an earnout transaction and the burden of proof imposed upon sellers, drafting of the earnout provisions becomes critical. Some of the more important provisions sellers and their counsel should consider including in any earnout based transaction include but are not limited to the following concepts:

  • Buyers should be prohibited from taking any action that would reasonably be expected to have a material negative effect on the EBITDA, results of operation or condition (financial or otherwise), of the acquired business.
  • Separate books and records of the seller’s business should be maintained throughout the earnout period.
  • Include clear examples of how the earnout will be computed based upon the definitions and provisions set forth in the transaction documents.
  • Limit the authority of the buyer to take certain actions without the consent or approval of a representative of the seller.
  • Provide that the seller’s key employees shall maintain operational control of the selling business during the earnout period.
  • Provide acceleration of the earnout in the event of a change of control of the buyer.
  • Provide a clear definition of “normalized” EBITDA, such as the elimination of inter-company fees or overhead charges, expenses relating to the transaction, and the arms-length pricing of the purchase or sale of inter-company goods and services.
  • Request that EBITDA be based on historical accounting practices of the seller v. GAAP.
  • The buyer should allow the seller to maintain adequate working capital consistent with past operations.
  • Clear dispute resolution provisions.

These are just a few of the many provisions that need to be negotiated in any transaction with earnout based consideration or compensation. That notwithstanding, many buyers are unwilling to accept pro seller earnout deal protection provisions and many times buyers are in a much stronger bargaining position. Sellers and their counsel should attempt to negotiate as many deal protection points as possible given the uphill battles a seller faces in a post-closing earnout dispute.

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