Managing earn-out provision litigation risk: avoiding common pitfalls

In any sale of a business, price is the most important negotiation. A buyer and seller rarely see eye-to-eye on value. What to do then when there’s a stalemate? Parties often rely on an earn-out—a mechanism that increases the purchase price if the business performs well after the sale. The seller hopes to earn a better price than the buyer is willing to pay upfront.

An earn-out will define a post-closing period during which one or more performance metrics are measured. When the earn-out period closes, are the parties “all good” no matter the outcome? The reality is that earn-outs are a common source of dispute and litigation. Studies show that their use in private business sales has materially decreased over the past decade, perhaps because of the headaches that often result¹. However, because earn-outs remain a fairly common provision in purchase agreements, it is useful to consider how drafting them can contribute to litigation risk.

The earn-out conundrum

A seller with an earn-out retains an interest in the business’s success after the sale, so the seller is motivated to dictate how the buyer will run the business. For example, if revenue is the applicable parameter, the seller will want the buyer to maximize revenue-generating opportunities without regard to the buyer’s costs. Conversely, the buyer wants the freedom to operate its new business as it sees fit without interference from the seller.

The lawyers responsible for the parties’ contract, therefore, have an important role in mitigating the risk of litigation by advising their clients to adopt metrics that align with the parties’ mutual incentives, drafting precise terms and expressly memorializing the parties’ commercial agreement.

Several recent decisions interpreting Delaware law illuminate some of the common hazards that earn-outs present, offering guideposts to buyers and sellers of all jurisdictions.

Looking at earn-out litigation risk through case law

When earn-out metrics are used to favour one party

In theory, the buyer and seller should have an equal interest in maximizing an earn-out because it tracks the business’s success. In reality, the chosen metrics play an important, even outsized, role in the likelihood of a dispute. The parties’ incentives can vary wildly if an earn-out is based on revenue vs. earnings, for example, particularly when the earn-out only measures the performance of a portion of the business.

In Shareholder Representative Services LLC v. Albertson’s Companies, Inc., the parties agreed to measure an earn-out on the company’s e-commerce sales, which had been the predominant source of revenues before the sale². The buyer’s internal documents acknowledged that the company’s post-closing success would depend on “investment in the [company’s] customer[s]”. The buyer instead shifted the business model to increase its own in-store sales at the expense of the acquired company’s e-commerce sales—and the business did not achieve the earn-out. The Delaware Court of Chancery allowed the buyer’s claim that the seller intentionally avoided earn-out payments to proceed, drawing a reasonable inference that the buyer intended to avoid short-term earn-out targets in favour of long-term gains.

When vague terms can muddy earn-out targets

Vague, ill-defined terms likewise heighten litigation risk, leading to arguments over, among others, the business lines included in the measurement, applicable accounting principles and the buyer’s required efforts. The parties in Fortis Advisors, LLC v. Dematic Corp., for example, agreed to measure an earn-out on the post-closing sales of “Company Products”, defined as the “products currently distributed or offered to third parties” by the acquired business³. When the earn-out was not achieved, the parties disagreed on whether “Company Products” included products made by integrating the acquired business’ software and other know-how into the buyer’s products.

The court aptly observed that “[i]n what is an all-too-predictable pattern in these transactions, the parties later became embroiled in a seemingly intractable dispute regarding whether the earn-out targets were satisfied.” Because the court concluded that the defined term was ambiguous, it permitted the parties to introduce extrinsic evidence, which they did during the course of a five-day trial, and, ultimately, the court found for the seller and entered a multimillion-dollar judgment in its favour.

When “good faith” requirements come into play

Litigation risk in the earn-out context is not limited to claims directly arising out of the purchase agreement but also extra-contractual “good faith” requirements. Buyers often negotiate for “sole discretion” to operate the business post-closing, but exercising that discretion may then be subject to an ill-defined and unpredictable “good faith” analysis.

In Retail Pipeline, LLC v. Blue Yonder, Inc., the court explained that, absent contractual language to the contrary, a buyer is not generally obligated to operate its business so as to ensure or maximize the seller’s earn-out payments⁴. However, a breach of the implied covenant of good faith and fair dealing may occur when the buyer’s conduct demonstrates that it “acted with the intent to deprive the seller of an earn-out payment”, such as by “actively shifting costs into the earn-out period that had no place there”. On the facts of that case, the court denied the seller’s claim because the evidence showed that the parties had discussed, but had not agreed, to require the buyer to make certain efforts that would have increased the chance of achieving the earn-out.

In a similar case, however, the court observed that when “comprehensive and explicit” terms “demonstrate that the parties contemplated that a dispute might arise concerning the operation of the business post-closing, specifically whether the purchaser was acting in a manner that maximized the earn-out,” the seller cannot resort to an implied covenant claim for rights it had “failed to secure for [itself] at the bargaining table”⁵.

The recent decision in FMLS Holding Co. v. Integris BioServices, LLC, suggests that an expressly stated obligation of the buyer to act in good faith may have more teeth than the implied covenant of good faith⁶. There, the court allowed the seller’s good faith claim to proceed where the buyer delayed hiring key recruits until after the earn-out period had expired. The parties in FMLS had agreed that the buyer “shall have sole discretion with regard to all matters relating to the operation” of the company, provided that they “shall not, directly or indirectly, take any actions or omit to take any actions in bad faith that would have the purpose or effect of avoiding or reducing any earn-out payment hereunder”. The court found it plausible that the buyer was motivated to extend the hiring process as late into the earn-out period as possible to avoid making additional payments to the seller.

Business takeaways to mitigate risk

1. While earn-outs can serve as a quick fix to bridge the value gap to close a deal, they often result in kicking the can down the road to time-consuming and costly litigation unless the parties and their lawyers carefully and cogently memorialize the parties’ mutual understanding into the purchase agreement.
2. If you incorporate an earn-out in your transaction, choose metrics that align with both the buyer’s and seller’s incentives and do not require complicated calculations to validate.
3. Avoid reliance on extra-contractual “good faith” analysis or extrinsic evidence in proving up contractual earn-out provision adherence by ensuring the provision contains specific, well-defined, detailed and clear triggers for meeting the parties’ agreed-upon performance metrics.