John Jenkins at the deallawyers.com blog highlights a recent Delaware case* where an asset purchase agreement included a post-closing contingent payment, as well as the following:
“Subsequent to the Closing, Purchaser shall have sole discretion with regard to all matters relating to the operation of the Business. Purchaser shall have no express or implied obligation to the Seller […] to take an action, or omit to take any action, to seek to maximize the Earn Out payment by seeking to maximize sales, pursuing particular business opportunities, engaging in advertising or marketing campaigns, or otherwise. Purchaser owes no duty, as a fiduciary or otherwise, to Seller […] in connection with its operation of the Business following the Closing.”
Earn-outs are among the most litigated provisions of purchase agreements, and the just quoted language focuses on one of the key reasons why. At closing, the buyer has taken ownership of the business. Its profits and losses are the buyer’s, the liabilities of its operations going forward are the buyer’s, and the buyer naturally expects to control the business. An earn-out challenges this clean break – the seller retains a stake in the results of the business after closing, and in order to protect its potential post-closing payments the seller would like to constrain what would otherwise be the buyer’s absolute control of the business.
The quoted language is among the more buyer-friendly provisions available to address this conflict – Jenkins colorfully describes it as “hit[ting] the seller with a two by four[.]” It is nonetheless far more common than the pro-seller mirror image that would have the buyer commit to maximize the earn-out, potentially at the risk of causing the buyer’s business as a whole to suffer (e.g., by directing all advertising to promote the purchased business to the detriment of the buyer’s other business lines).
Depending on the particular characteristics of the business and transaction, a seller may be able to protect their earn-out against a buyer’s bad faith or certain foreseeable ways of gaming the calculation of the earn-out. Close consultation with counsel and accountants on the terms of the earn-out should start as early as possible in the transaction process – don’t wait until after an initial term sheet to do this.
And do think twice about whether you actually want to include an earn-out in your deal. Earn-outs are said to be popular because they allow parties to bridge valuation gaps – which, translated into plain and rather cynical English, means parties can do deals despite the fact that the buyer and seller can’t agree on the most fundamental of business terms, the value of the purchased business. All else being equal, consider whether you can avoid the uncertainties of a post-closing earn-out dispute by better quantifying the variables and probabilities of future financial results to arrive at a final negotiated price today.
* Collab 9 v. En Pointe Technologies Sales (Del. Super.; 9/19)