Delaware Chancery Court provides helpful drafting tips in Earnout case

After taking the summer off from blogging, its time to write again. I thought I would go back to one of my favorite topics to discuss - one often ripe for dispute - earnouts. An interesting decision by the Delaware Chancery Court last month raises some drafting issues.

The case involves a dispute over an EBITA-based earnout between sellers of a life-sciences startup and buyer, AmerisourceBergen Corporation. The deal involved a $21 million closing payment and an earnout of $55 million based on 2003 and 2004 results. Because Sellers saw this deal as giving them access to a larger marketing platform, they obtained buyer's agreement to exclusively promote seller's products as part of AmerisourceBergen's marketing pitches. The merger agreement also included language expressly requiring buyer to use "good faith" and not undertake any actions that would impede the earnout benefits to the sellers.

Notwithstanding these seller-favorable provisions and a finding by the Court in favor of liability for breaching the agreement, on this issue the Court only awarded nominal damages of 6 cents. (The Court did award $21 million on a separate claim that the earnout metric was miscalcuated, so the sellers did have something to celebrate). So, a liquidated damages clause may have been useful here to the sellers.

Another issue was cost control as related to the earnout computation. The agreement clause did not prevent sellers from controlling (reducing) its expenses during the earnout period. A buyer in this case may consider providing that any reductions in expenses (that are not buyer-approved) will get backed out of the EBITDA or other similar earnout metric. Conversely, sellers should try to control as much of the action as possible, so buyer's increases in overall corporate spending do not dilute their earnout.

The term "average" was also in dispute. Buyer argued that average meant "weighted average," while the contract was silent. The court did not find this argument compelling ("the most straightforward usage of the term 'average' is an arithmetic mean, or an average in which each term is given equal weight"). So, if you mean weighted average, you need to say so in the agreement and then spell out the rules on how the weighting is going to work.

The case also presents an example where the parties departed from GAAP in defining the Adjusted EBITA and the Court enforced their agreement, as opposed to referring back to what GAAP may require.

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.

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.

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.