Delaware Chancery Court rules on post-closing adjustment dispute

A March decision of the Chancery Court in Matria Healthcare v. Coral SR LLC is an essay on post-closing adjustment (true-up) provisions and the interplay of dispute resolution mechanisms in a purchase agreement.

The case involved a merger between two companies in the disease management and wellness business, Matria and CorSolutions. Apparently, before the closing CorSolutions received some complaints from a key customer about their bill and failed to disclose that to the buyer. Matria got the call from the customer - one day after closing - and then spent the next six months negotiating what turned into a $4 million settlement. This was done without discussion with the seller and without their consent. After the settlement, Matria sought relief from the seller for their payment and the dispute ensued.

To complicate things, this agreement had four different types of dispute and resolution mechanisms, two of which are relevant here. The first was a typical post closing adjustment (true up) provision relating to balance sheet adjustments for things like working capital, cash on hand, indebtedness, etc. Disputes arising from adjustments would be submitted to an outside accountant (a “Settlement Accountant”). These claims were not limited by a cap and would be adjusted on a first dollar basis.

Other claims by the parties relating to the transaction, such those arising from breaches of representations, warranties or covenants, would be handled by a AAA arbitration. These claims would be resolved against a $20 million escrow fund, and were subject to a basket (i.e. deductible) of $4.5 million. The agreement also provided a typical exclusive remedy clause where all claims other than fraud or for injunctive relief would be limited to the escrow fund.

The court noted that, in anticipation of a potential hierarchy issue stemming from the different ADR provisions, the parties also provided that any claim that could be brought related to the financial statement adjustments will be subject to that provision and not subject to the escrow fund. ("The items set forth on or reflected in the [financial statements delivered in connection with the true-up] and any matters relating thereto that could have been subject to adjustment or dispute pursuant to [the true-up] are subject solely to the adjustments set forth in Article II [i.e. by the Settlement Accountant] . . . and accordingly shall not be subject to any claim by [Matria]… on the Escrow Fund.”)

If the claim went before the Settlement Accountant, Matria may recover fully on its $4 million claim; if it goes before the AAA, they will likely get nothing since it will be wiped out by the $4.5 million basket. Therefore, it is not surprising that the parties could not agree on the forum.

The interesting part of this decision is the analysis of how Matria’s claim arising from the customer complaint could be characterized under the agreement. The Court noted that the claim could be (1) a potential claim, serious enough to be reflected on CorSolutions’ balance sheet, and therefore properly before the Settlement Account on a first dollar basis; (2) a misrepresentation based on a failure to disclose and a breach of various representations and warranties and, thus properly before the AAA and subject to the cap and basket ; and (3) a Third-Party Claim pursued by the customer, where yet a third mechanism from indemnity and damage relief would apply. The discussion appears on pp. 15-16 of the decision.

At the end of the day, the court being predominately known for its strict construction, directed the dispute to the Settlement Accountant on the basis of the hierarchy clause that was in the agreement, albeit with some reluctance. (“The result reached here is, in large part, unpalatable; it is the product, however, of words chosen by sophisticated parties who drafted a complex and comprehensive agreement. More importantly, it is not for some judge to substitute his subjective view of what makes sense for the terms accepted by the parties.”).

The moral of the story here is that these are very complex provisions that really need to be tested by the drafters in advance to make sure that they will work in the field. The Matria decision has a lot of other interesting nuggets for transactional lawyers relating to arbitrability, contract constuction and drafting examples (that may or may not work, depending on one's viewpoint) and therefore worth a closer a read.

Federal court rules for Buyer in earnout case

Earnouts are rife with controversy. While they are popular in today’s deal market, and most parties see them as a creative remedy to bridge a pricing or funding gap, the majority fail and result in disputes. Assuming the best of intentions to honor the original agreement, it is impossible to predict all of the parameters that may impact a future earnout potential. A recent decision by the US District Court for E.D. of Wisconsin, Didion Milling, Inc. v. Agro Distribution, LLC (2007 WL 702808) is a good primer of some the issues that may need to be tested at the purchase agreement stage.

The earnout here was based on a net cash flow determination, where the APA provided a list of guidelines on how it would be calculated, including a reference that GAAP would be used. Despite a provision in the APA that the agreement could not be assigned, the buyer assigned the agreement to another entity, which in turn assigned it again, so that the party owing the earnout was not the original buyer. Since the earnout was based on a calculation of the original business acquired, this complicated the earnout calculation not to seller’s liking.

One issue was that net cash flow was supposed to take into account after-tax numbers. The original buyer was a corporation, so it paid its own taxes. The ultimate successor was an LLC, a pass-thru, so the tax rates and rules would be different, and would not be paid by the business but by its members. This created ambiguity as to whether taxes should be included, and if so, how much. This is probably something that, now with 20-20 hindsight, should be addressed specifically in the purchase agreement.

The parties disagreed as to the interest deduction against the earnout calculation, and whether the buyer’s overall cost of capital can be used to apply across the board. Again, probably something that can be spelled out in advance, at least by plugging in numbers for min/max.

Finally, this case also involves a claim for good faith and fair dealing, which is common in earnout cases. To provide the flavor what is usually alleged, the plaintiffs claimed that each of the following was a separate reason to find bad faith: (1) buyer acquired the business aware that seller had not consented to the assignment; (2) buyer focused on reselling the business rather than operating it; (3) buyer failed to provide seller with monthly financial statements; (4) buyer failed to provide seller with the documentation necessary to support calculation of net cash flow; and (5) buyer engaged in “sharp dealing” by assessing taxes, charging interest, and early expensing of payment. The court rejected all of these as a matter of law.

A couple of these deserve comment. On the consent issue, the court noted that while a good faith claim did not work here because the ultimate buyer had no privity with the seller under the original seller, there could be a claim for intentional interefence with a contract (which was not alleged here).

On “sharp dealing”, the court explained that a party may violate the duty of good faith by taking deliberate advantage of another party’s oversight. Such sharp dealing may or may not be actionable in tort. Actions such as avoiding an unbargained for expense or obtaining an advantage by way of exploiting superior knowledge do not, however, constitute sharp dealing or a breach of the duty of good faith.

Indemnification rights in venture deals

While the venture market still seems flush with cash, a number of recent litigations involving venture firms (such as the Hummer Winblad case now in seemingly constant discussion) are driving the market to seek additional protections from their portfolio companies upon investment and afterwards.

In particular, some investors are now asking for indemnification from the company akin to the measures in an acquisition agreement. Companies looking to oppose these provisions should know that they are generally rare. While an indemnity is market where the deal presents some liquidity to the founders or other investors. this is not common in the venture context. The VC investors typically have board seats, observation and information rights and strong covenants, so they are in a position to see how the money is spent. If they don't have then, this presents a bargaining chip for the company in exchange for the indemnity being sought. They also have the right to sue the company for breach of the reps or fraud while there is still money to pay the claim. Unlike an M&A deal, venture round docs usually don't have exclusive remedy clauses.

A later stage financing certainly is more likely to give concern to the investor about the unknown that cannot adequately be tested through due diligence, but it would be unfair to shift that risk to the founders. If I am a VC asking for this provision and getting it regularly, I have to ask kind of company (and founder team) am I investing in if they will accept those terms. The
better the terms for the VC, the more apparently becomes the adverse selection problem.

One way to deal with the issue is to ask the investors their specific concerns. If there is a known problem, such as a litigation, a 409A problem, etc., that can be dealt with through traunches, escrow etc, without personally impinging on the Founders . The NVCA model docs address this issue parenthetically by having certain reps be made by the Founders, where the "Founder's liability for breaches of any provisions of this Section 3 shall be limited to the then current fair market value [as determined in good faith by the board of directors of the Company and such Founder [may, in his sole discretion, discharge such liability by the surrender of such shares or the payment of cash] (note FN1 and FN2 below from the docs). The NVCA docs are intended as a fair starting point for a Series A round, and they do not contemplate an indemnity. Finally, another approach may be to allow the indemnity, but to limit all recourse to the Founder's shares. The risk here, of course, is the precedent for the next round.


[1] Founders' representations are controversial and may elicit significant resistance. They are more common in the Northeast and counsel should be warned that they may not be well received elsewhere.
They are more likely to appear if Founders are receiving liquidity from the transaction or if there is heightened concern over intellectual property (e.g., the Company is a spin-out from an academic institution
or the Founder was formerly with another Company whose business could be deemed competitive with the Company). Founders' representations are not common in subsequent rounds, even in the Northeast, where risk is viewed as significantly diminished and fairly shared by the investors rather than being disproportionately borne by the Founders.

[2] Investors should consider whether cash is an acceptable remedy; the cash value of the shares is likely to be low, particularly if there has been a breach of a rep or warranty. In addition, if the Investors require the surrender of shares rather than cash, they should also consider whether to include Preferred Stock, as well, if the Founder owns shares of Preferred.

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.

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.

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.