Earn-outs, sharks, and dolphins

The past few weeks have brought additional opinions from the Delaware courts regarding earn-outs – as Vice Chancellor Glasscock notes, a not uncommon occurrence:

A recurring scenario in this Court involves disputes between buyers and
sellers of entities over earn-out provisions for post-acquisition performance. The incentives peculiar to such agreements, perhaps, make disputes, if not inevitable, common.

In Quarum v. Mitchell Int’l (C.A. No.: N19C-03-087), an aggrieved seller of a business argued that the buyer had acted in a fashion that deprived the seller of the full value of a post-closing earn-out. In the acquisition agreements, the buyer had promised that it would “avoid taking actions that would reasonably be expected to materially reduce” the amount of the earn-out. The seller alleged that the buyer had breached this commitment by, inter alia, failing to promote the purchased business to its customers.

In the January 21, 2020, Superior Court decision in Quarum, Judge LeGrow relied on the distinction between affirmative and negative covenants to deny this portion of the seller’s claim. The seller, wrote the court, was misreading the plain language of the covenant just quoted – it was a negative covenant that required the buyer to avoid certain acts, but not an affirmative covenant that required the buyer to do anything in particular to promote the product. The court agreed with the buyer that the seller’s reading would “effectively place the power to manage the company in [the Seller’s] own hands.”

Which is, of course, the original sin of the earn-out. When you hand the buyer the keys to the car, the buyer expects to be able to drive it as she sees fit. An M&A buyer is not by nature a passive investor in the sold business – they are buying it because there are things they want to do with it, whether on its own or in combination with their existing businesses. A seller who wants continued control shouldn’t sell – the best they can bargain for is protection against the most egregious forms of gaming the deal.

The quote from Vice Chancellor Glasscock with which I began comes from a second earn-out case decided earlier this week, the February 19 decision in Claros Diagnostics v. Opko Health (C.A. No. 2019-0262-SG). That case, decided on laches grounds, involved a deal in the biotech space with an earn-out based on the achievement of certain milestones, including FDA approvals.

While these types of milestone-based contingent payments are generally grouped together with revenue-based contingent payments as “earn-outs,” I would suggest that they belong together in somewhat the same way as sharks and dolphins are (or are not) both “fish.” While they are both payments contingent on future events, the milestone based earn-out addresses uncertainties that are fairly binary in nature. Either the FDA will or it won’t approve your new drug or technology, with a huge gap in the economic consequences. There is a fairy compelling argument under these circumstances that it is not reasonable for the parties to try to reduce the probability-adjusted value of these two very different outcomes to a single fixed purchase price paid at closing.

Revenue-based or similar earn-outs don’t usually have these binary uncertainties to be dealt with – the probabilities of different future outcomes chart as a curve, not a cliff. The broader the curve, the more likely one or both parties will try to use an earn-out to make a deal happen – but the risks the parties are dealing with are on an overlapping continuum with those in deals in which the parties agree on an upfront one-time closing price. They may have some outward similarities to the milestone based contingent payment, but the internal rationale is qualitatively different,.

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