I observed in my prior post that the seller of a business will seldom obtain a commitment from the buyer to operate the purchase business in such a manner as to maximize the amount of post-closing contingent or earn-out payments. There are exceptions, of course – a search of purchase agreements included in SEC filings on EDGAR yielded this example that comes close:
“Buyer will act in good faith and, acting as a reasonably, skillful, prudent, and diligent person engaged in the independent operation of a business similar to the Business of the Corporations, use its reasonable best efforts to enable the Corporations to earn the Minimum Pre-Tax Profits during the Earn-Out Period, including providing the Corporations with sufficient liquidity in order to make the capital expenditures contemplated in the agreed-upon budgets of the Corporations[.]”
More commonly, however, the best a seller can hope for is to put some guardrails on the purchaser’s freedom of action after the deal closes. Sellers have done this in a variety of ways, some more meaningful than others:
Commitments to act in good faith, or not to act in bad faith: Most buyers and their counsel will regard these as easy gives, since they do little more than restate an obligation that the law in many states will read into a contract in any event. However, note that in the case cited in my prior post the Delaware court decided not to read an implied duty of good faith into the earn-out at issue. A seller therefore has a strong incentive to make the implied duty of good faith explicit.
Operational guarantees of transparent accounting: Earn-out provisions may require the purchaser to operate the purchased business as a separate legal entity or division as a way of ensuring that post-closing accounting can be done on an apples-to-apples basis with the pre-closing financials on which the earn-out targets are based. The agreement may also, or instead, mandate that the buyer maintain separate books and records for the purchased business.
Covenants based on purpose or intent: There is a wide scale of commitments a buyer can be asked to provide that restrict the buyer from taking certain actions to reduce the seller’s potential earn-out. At the most favorable to the seller, this could be a prohibition on the buyer doing anything that the buyer knows or is aware would reduce the earn-out. More common, however, is a prohibition that looks at the buyer’s purpose in taking such an action. For example:
“Furthermore, Buyer shall not, directly or indirectly, take any actions in bad faith that would have the purpose of avoiding the Earn Out Payment hereunder.”
However, buyers often will qualify such prohibitions in order to reduce the risk that a single offhand remark about the effect of a valid business action on the earn-out will be interpreted as a sign of intent or purpose. The resulting provision will restrict taking actions with the “primary purpose” or “sole purpose” of reducing the earn-out amount. Of course, as a practical matter in most disputes it will be difficult or impossible to show that there was no valid business purpose to a buyer’s post-closing action other than its effect on the earn-out.