Fourth Circuit Court of Appeals opines on earnout in roll-up case

To take a little break from recent posts on Delaware case law, I thought I would comment a little on a new decision by the Fourth Circuit involving an earnout provision. The case, Vaughan v. Recall Total Information Management, can be read here. Vaughn involves a failed earnout in a roll-up acquisition and presents an interesting case study.

Earnouts have become prevalent in today's M&A environment. Buyers often are cautious about projections offered by sellers and rely on earnouts to reach a middle ground. The difficulty lies in agreeing on earnout targets and formulas. Sellers typically prefer to measure in terms of sales/revenues, while buyers want to measure actual profitability of performance, often using relying of EBIDTA or net income as a metric. While an earnout may be a decent option for a seller that intends to stay involved in the business, for a business owner (such as financial investor) that truly wants an exit, it presents a substantial risk. Conversely, buyers are often at risk for being a target for litigation when things go wrong and targets are not met.

The Vaughan case illustrates some of the potential problems with earnouts. Seller (SDA) ran a successful document shredding business that was acquired by Buyer (Recall). The total price was approximately $27 million, with almost $12 million being subject to an earnout payable in two installments over 12 months after closing. The earnout formula was based on sales revenues of buyer, and to earn the full earnout, the revenues for the acquired business would need to increase almost 50% over the 12 month earnout period. This aggressive target, together with heavy weighting of the earnout (app. 40% of the total price), put this deal in a high risk category.

Not surprisingly, a key issue in the litigation was whether seller was entitled to count certain sales revenues of buyer toward the earnout. After this acquisition, Recall acquired a number other document shredding companies. A key question became exactly who was responsible for the acquisitions, and for the revenues they ultimately delivered. The Agreement defined Sales Revenue broadly, to include "all gross revenue generated by the Company from new contracts or agreements from any source for document shredding services." The earnout provision in the Purchase Agreement also placed an express duty on the Buyer to use good faith allow Seller to maximize its earnout potential ("Purchaser agrees to act reasonably in good faith to allow [Seller] to have a fair opportunity to qualify for the maximum payments provided for by this [earnout]....").

Intepreting this provision, both the Fourth Circuit and the underlying federal trial court found that the sales revenues should include those from certain follow-on acquisitions. Considering how broad the "any source" language was, this decision is not surprising. The court also acknowledged that while this result may be due to poor drafting, it is not their role to supervene. ("While it is conceivable that the parties' failure to be more explicit concerning Recall's subsequent acquisition revenue was due to poor drafting rather than the actual intent of the parties, it is not the role of the court to speculate or rewrite the terms of the Agreement....")

Vaughn presents a good case study for companies engaged in roll-up strategies, and to their sellers. If follow-on acquisitions, or "tuck-ins" are planned, it is important to expressly carve them out of any earnout provision. Sellers, on the other hand, need to protect themselves from the unknown. If you can get paid in cash and get it upfront, good work. If not, dont assume you will ever get your full earnout. It is probably unrealistic for most sellers to demand consent rights or a buyout of the earnout in the event of follow-on acquisitions. That said, sellers may be wise to insist on a careful segregation of the sold business to facilitate an earnout calculation, and as here, to insist on "good faith" language to encourage the buyer's good behavior.

Delaware court comments on "spring loaded" options

This has been an interesting month for stock option decisions. As mentioned in my prior post, a few weeks ago the Delaware Chancery court took a hard line against backdating option practices in Ryan v. Gifford (now available on the Chancery Court's website here).

Another decision issued on the same day (2/6/07)is In re Tyson Foods, an opinion written by Chancellor Chandler. The relevant part of this case is the discussion on "spring loaded" option grants issued by the Company to favor executives. Ok, so what are "spring loaded" options? The court explains that the are options granted right before a company makes an announcement that is expected to have a positive result on the stock price. The converse of this practice are "bullet dodging" grants, where the grants are timed to take place after the impact of an announcement that is anticipated to depress stock price, thereby giving the benefit of a lower strike price.

This theory of liability is interesting because it is different than straight backdating. As the court points out, backdating has the inherent problem of falsifying information about the grant itself. The date of issuance is false, as is the representation to stockholders that the option was granted at fair market value on its grant date. Spring loading, however, does not necessarily face the same ethical issues. As the court notes, a company may be justified in knowing issuing options that are in the money to executives, as a means to retention and providing performance incentives. The problem lies with disclosure.

The court notes that "[t]he touchstone of disloyalty or bad faith in a spring-loaded option remains deception, not simply the fact that they are (in every real sense) 'in the money' at the time of issue. A board of directors might, in an exercise of good faith business judgment, determine that in the money options are an appropriate form of executive compensation.... A company with a volatile share price, or one that expects that its most explosive growth is behind it, might wish to issue options with an exercise price below current market value in order to encourage a manager to work hard in the future while at the same time providing compensation with a greater present market value. One can imagine circumstances in which such a decision, were it made honestly and disclosed in good faith, would be within the rational exercise of business judgment...."

The interesting common thread between both decisions is the overtone relating to good faith/bad faith by directors. Some commentators have already noted that this arises from the Disney decision from 2006 where the Delaware Supreme Court elaborated on what some see as a new duty by the board, one of good faith. This analysis seems to allow for a private right of action under state law against directors, where theories under federal law for insider trading have not gotten much traction with the courts. (“To act in good faith, a director must act at all times with an honesty of purpose and in the best interests and welfare of the corporation.”)

The court also notes in dictum that a director may be absolved of liability if shareholders have expressly empowered the board of directors (or relevant committee) to use backdating, spring-loading, or bullet-dodging as part of employee compensation, and that such actions would not otherwise violate applicable law. It seems like this language could be useful in drafting future plans, although it begs the question as to what impact it would have under 409A, where you may still run into a problem for issuing options below fair market value.

IRS issues tax reprieve for backdated options

Last week the IRS announced an initiative aimed to relieve for rank-and-file employees (as opposed to company executives) affected by backdated and other mispriced stock options. The announcement can be read here.


An employee who exercised a ‘backdated’ stock option in 2006 may owe an additional 20-percent tax, plus an interest tax, under the Federal tax laws governing deferred compensation. If the option had been properly priced, the employee normally would only have owed income tax on the difference between the value at the date of grant and exercise.
The initiative allows companies to step forward and pay the additional 20-percent tax and any interest tax that employees owe.

Employers and employees must both act quickly. Under this initiative, employers must notify the IRS of their intent to participate by Feb. 28, 2007. The employers, in turn, will be required to contact affected employees by Mar. 15, 2007 to inform them that the employer has applied to participate in the Compliance Resolution Program.

Delaware Chancery Court weighs in on option backdating controversy

This month the Delaware Chancery Court wrote a very strong opinion indicating that its position on option backdating is not likely to be a light one. In Ryan v. Gifford (which may soon be available online for on Delaware’s court site, but for now just on WESTLAW (2007 WL 416162), the Court refused to dismiss a case brought against the Board of Maxim Integrated for backdating options. The decision provides very strong language that suggests that the Delaware courts are going to be very critical of this once-widely accepted practice.

* For example, the opinion provides that backdating options qualifies as one of those “rare cases [in which] a transaction may be so egregious on its face that board approval cannot meet the test of business judgment, and a substantial likelihood of director liability therefore exists.”
* In a footnote, the Court reminded that backdating may expose Boards not only to potential civil liability, but also to potential criminal liability for securities fraud, tax fraud, and mail and wire fraud.

While this decision takes place at a juncture of a motion to dismiss, where courts are generally wary to throw out a case when there has not been sufficient opportunity to explore the facts, the tone of this decision is grave. It will be interesting to watch as this and other cases evolve.

What do VCs want from their CEOs

What do VCs really want from their CEOs? A recent study by VentureOne shows that #1 is sales and marketing, followed by operations leadership, financial management and product development.

The study summary can be found here

This study of VCs and CEOs reflects some interesting, but not surprising statistics about board members in startups and tech companies.

• most companies have 4-7 board seats, with 4-5 being the highest out of that range. 5 is a pretty common number, since that avoids a deadlock.

• in about 1/3 of the companies, the VCs hold 20-40% of the seats; in about 1/3, it's 40-60%. Again, a board of 5, 1-2 seats is commonplace.
• conversely, company management holds 20% or less on most boards - 1 seat for the CEO then in office is pretty common. If that CEO is also the founder, and later is displaced from the CEO office, it is common for the founder to remain as the Chairman of the Board.
• As far as compensation for Board membership, it looks like most companies do not compensate their directors in any way, and that a minority does so with stock options. Cash and stock seems to be a more phenomenon, which makes a lot of sense considering how cash dependent most startups tend to be.
• It is a bit surprising to find that both VCs and CEO agreed that the most significant value of a VC boardmember is for help with financings and locating investors. The answer I would have expected from the VCs is their business expertise and strategic vision is their most valuable asset. Sales and marketing experience is valued, albeit in second place.
• Finally, "dilution of investment" is cited as the biggest factor of conflict on a board. This is a good reminder that while your investors are usually aligned with the founder's interests, when it comes investment time, all bets are usually off and its every man (or VC) for him/herself. This is especially true if you have been lucky enough to have had multiple investment rounds (or "series") and have various illustrious investors on your board. Since this is something that most investors fully acknowledge, founders should not be afraid to voice their concerns about potential conflicts and should seek to have at least some disinterested (independent) directors on their board.

Recent Massachusetts case on corporate freezeouts

A recent decision by the Massachusetts Supreme Judicial Court (SJC) found that in a close corporation context, the estate of one of the company’s founders that was a minority shareholder was not entitled to a buyout. See here for the opinion: http://www.socialaw.com/slip.htm?cid=16741&sid=120

The court stated that in a freeze-out situation, the buyout is not the only reasonable remedy. Instead, since the freeze-out denies the minority’s “reasonable expectations of benefit” of being a stockholder, the remedy should, to the extent possible, restore to the minority shareholder those benefits reasonably expected, but not received because of the breach.

The court explained that “in ordering the defendants to purchase the plaintiff’s stock at the price of her pro rata share of the company, the judge created an artificial market for the plaintiff’s minority share of a close corporation — an asset that, by definition, has little or no market value.” This is a very interesting position, considering all of the ado over 409A and stock option valuations for startup companies in the last few years.

Recent Massachusetts case defines defacto merger

A recent Massachusetts appeals court decision defines Mass law regarding defacto mergers and successor liability regarding environmental claims. The case can be found here: http://www.socialaw.com/slip.htm?cid=16545&sid=119

This case summarizes as follows the Mass law regarding defacto mergers:

Factors considered in determining whether a sale should be treated as a de facto merger are: “whether (1) there is a continuation of the enterprise of the seller corporation so that there is a continuity of management, personnel, physical location, assets, and general business operations; whether (2) there is a continuity of shareholders which results from the purchasing corporation paying for the acquired assets with shares of its own stock, this stock ultimately coming to be held by the shareholders of the seller corporation so that they become a constituent part of the purchasing corporation; whether (3) the seller corporation ceases its ordinary business operations, liquidates, and dissolves as soon as legally and practically possible; and whether (4) the purchasing corporation assumes those obligations of the seller ordinarily necessary for the uninterrupted continuation of normal business operations of the seller corporation.” Cargill, Inc. v. Beaver Coal & Oil Co., 424 Mass. 356, 359-360 (1997).

The court noted that one key is looking at continuity of management, employees and shareholders.

This decision is also instructive on the liability a buyer would assume pursuant to express language in a purchase agreement. The court found that buyer’s assumption of liabilities of seller “as then existing” pursuant to an asset purchase agreement was not sufficient to hold that buyer assumed CERCLA liability then unknown.

CEO transitions in life of venture-backed startup

Most startups suffer high staff turnover, and their CXO’s are no exception. In the short but exciting lifespan of a venture backed startup, it is not unusual to see two or more CEOs and other CXOs rotate through the company to navigate it through the rough waters of going from idea to beta to market, and so on.

See the following link for a recent whitepaper that honestly discusses this point: http://www.pwcmoneytree.com/exhibits/RitesOfPassageArticle.pdf

While experienced, or “repeat”, CEOs are less prone to find themselves in this position, most early stage executives may find that the investors want to make a change or bring in a more specialized industry player with execution success. Founder teams that plan to seek investment capital are wise to plan for such a potential change and position themselves in the company where they could have a long-tenured position. Discussing this issue upfront with their investors and negotiating appropriate employment agreements is always a good idea to give both sides the comfort and incentive necessary for promoting the overall success of the business and gaining the investors’ trust.

PWC Moneytree Survey shows increase in VC investments into Media and Entertainment

PWC Moneytree Survey shows increase in VC investments into Media and Entertainment

The PWCMoneyTree Survey for Q4 2006 shows in increase in deals over the last 5 years. VCs invested over $25 billion in 3,416 deals in 2006, a 10 percent increase in deal volume and a 12 percent increase in dollar value. 2006 had significant growth in life sciences, biotech and medical devices, and a strong year for Media/Entertainment, Energy and Web 2.0 companies. In particular, Media and Entertainment companies raised $1.6 billion in 299 deals (compared to 2005 when $1 billion went into180 deals). Telecom raised $2.6 billion, with wireless accounting for 44 percent of the Telecom sector deal size. The study and related links can be found here: http://www.pwcmoneytree.com/moneytree/index.jsp

New England had over 400 deals in 2006 (11% of national deal volume in deal size), second only to Silicon Valley, which had over 1100 deals (35% of national deal volume in deal size).

Another report provides valuation tracking going back to 1997. The average pre-money valuation for “Early Stage” (i.e. Series A) seed level deals for Q3′06 was just over $6M, with a typical seed round around $5.6M. Expansion Stage deals (i.e. Series B or Series C) had an average pre-money valuation of $54M, with an average deal size of $13M. The report can be read here http://www.pwcmoneytree.com/exhibits/Valuations_95_06Q3_12MonthRollingAvgs.xls

Recent Delaware and Maryland cases interpret redemption rights

Today’s VC deals (at least on the east coast) are likely to contain a redemption clause in the charter of the company, giving the investors a “put” right to make the company buy back their investment after some period of time has passed (usually 5 yrs or more). VC funds have their own investors and want to see an exit within the same period, so the redemption right gives some additional (perhaps illusory) protection to the investors that they can cause the company to liquidate their position. Of course, if the company does not have the money, little can be done. The concept really works only when the company is financially stable, but the other stockholders do not want to liqudate their investment or sell (i.e. perhaps it is lifestyle company or there is disagreement on timing), which allows those with the put rights to seek a buyout.
Several recent decisions help interpret the scope of redemption rights in context. In Harbinger Capital Partners v. Granite Broadcasting, the Delaware Chancery Court ruled that preferred stock that was mandatorily redeemable by the company was still equity, not debt. The case can be read here. The preferred stockholders sought to enjoin a sale of assets by the company by claiming that they were a creditor, and the sale a fraudulent conveyance. Their argument was based largely on a recent change in accounting rules under GAAP and FASB that provided for a debt treatment of certain types of preferred stock with redemption features. The court rejected that theory. Relying on a long line of cases, it held that the rights of shareholders to recover dividends or to redeem their stock is dependent on the financial solvency of the corporation,’ and is therefore not a fixed liability.” Marking its territory, the court also noted that FASB was neither lawmaker nor judge,” and should not have “the power to fundamentally alter the law’s understanding of the role of preferred shares.”
Another 2006 case by a Maryland state court had a different take on the issue. In Costa Brava Partnership III v. Telos, (2006 WL 1313985) investors argued that their preferred shares were debt because they “lack voting rights in most circumstances, yield fixed dividend payments, maintain a fixed maturity date, have redemption and liquidation rights which do not exceed the security’s issue price, retain priority over common stockholders, and are classified as “indebtedness” in the corporate charter. “ They also argued that the company itself classified its accruing dividend obligations as debt on its financial statements. The court stated that such conduct by the company would indicate the preferred stock is to be treated as debt. Therefore, without expressly ruling on the issue of whether the investor can be considered a creditor, the court refused to dismiss a claim for fraudulent conveyance (which can only stand if ultimately Costa Brava is found to be a creditor).
Another 2006 Delaware Chancery Court decision, Thoughtworks v. SV Investment Partners (aka Schroeders), provides an interesting introspective on how courts interpret the mechanics of a redemption provision, and perhaps a useful roadmap on how they are negotiated. The case can be read here: http://courts.delaware.gov/opinions/(w0fpgu55x0mqkc45box4kbml)/download.aspx?ID=79250. In typical Delaware court fashion, the court interpreted the redemption language in the charter very strictly and refused the company to delay its redemption payments to fund working capital. The court looked at the history of negotiations, where the Company originally wanted to carve it entire budget out of available funds for redemption but the parties finally agreed on a carveout for a particular year (2005). In light of the Harbinger case I am not sure what of the ultimate impact in this case, when it seems that the company may have trouble making the payment in any event.
Notwithstanding the strict constructionist approach on redemption, the court in Thoughworks took a different tack on interpreting a negative covenant in the charter. The negative covenants did not expressly reference a material indebtedness provision, requiring consent only for any contractual arrangement providing for the payment of $500,000 or more.” The Court found that “such contractual arrangements can be easily read to include debt transactions.” (I am not sure I agree). This finding by the Court is a bit of a surprise, as I think most corporate and vc lawyers would find the language to be lacking.