Acquiror fails to live up to commitment to "actively and exclusively" promote target's products after merger, in violation of key earn-out commitment; also found to have miscalculated the earn-out
LaPoint v. AmerisourceBergen Corp.
Court of Chancery (Delaware)
September 4, 2007 . Civil Action No. 327-CC
While earn-out arrangements can help get deals done, they often create "enforcement" issues after the merger. Ideally, earn-outs would be structured so that the new owner can't avoid the payments by artificially suppressing the business but at the same time is able to make ordinary business decisions even if they might reduce the value of the earn out. This Delaware decision shows some of the pitfalls of a poorly drafted earn-out.
Chancellor Chandler described the case as falling "into an archetypal pattern of doomed corporate romances". AmerisourceBergen Corp. ("ABC") merged with Bridge Medical, Inc., a start-up that had not yet turned a profit. An earn-out seemed a good way of compensating the selling shareholders fairly in the event that Bridge's business finally took off in the two-year period post-closing. The deal was accordingly structured as a $27 million up-front payment and an earn-out of anything from nothing to $55 million, based on EBITA.
The key provisions
Two provisions were central to the case:
[ABC] agrees to (and shall cause each of its subsidiaries to) exclusively and actively promote [Bridge's] current line of products and services for point of care medication safety. [ABC] shall not (and shall cause each of its subsidiaries to not) promote, market or acquire any products, services or companies that compete either directly or indirectly with [Bridge's] current line of products and services.
[ABC] will act in good faith during the Earnout Period and will not undertake any actions during the Earnout Period any purpose of which is to impede the ability of the [Bridge] Stockholders to earn the Earnout Payments. Unimpressed with this type of drafting, the court condemned the agreement's "gossamer definitions" and "aspirational statements" as "too fragile to prevent the parties from devolving into the present dispute".
Failure to promote Bridge products
The plaintiffs argued that ABC had not "exclusively and actively" promoted Bridge products to its hospital customers. Particularly damning, in the court's view, was an email from an ABC vice-president advising an employee that if a certain customer were to insist that it didn't want the Bridge product, it would then be fine to sell them a rival product that "we want to use". The employee was then asked to consider whether it "is too risky" to contact "someone at [the customer] and ask them for some assistance". In addition to this, ABC essentially prohibited the Bridge division from sending out press releases that it had relied on as a form of promotion. And finally, ABC turned down a merger agreement with a third company that would have been very favourable to Bridge.
The court accepted the Bridge shareholders' version of events as well as its conclusion that ABC had neither exclusively nor actively promoted Bridge. The main exception was the aborted merger - Chancellor Chandler held that ABC was not obliged to proceed with a merger that would not have been profitable because of the earn-out payments it might have triggered (or, more precisely, because of the cost of buying out the earn-out rights of the Bridge shareholders as ABC's proposed merger partner appears to have required).
Damages of six cents
In spite of its general finding against ABC, the court held that there was no evidence that the ABC's failure to promote Bridge had made a difference in a market that was moving away from Bridge's type of product. Damages were thus only nominal, which in Delaware turns out to mean six cents.
The 2003 earn-out
The Bridge shareholders also asked the court to rule that ABC's calculations relating to the 2003 earn-out had deprived it of millions. The court agreed, finding that ABC's proposed interpretation of the earn-out amounted to a request for the court to re-draft it. This it would not do, even though Chancellor Chandler agreed that that the plaintiffs were "craftily" taking advantage of some very bad drafting.
The first drafting mistake was an R&D clause providing that Bridge must remain within 80% of a projected figure ("X"). When actual R&D expenditures did not meet this target, and in fact fell $1.25 million short of X, ABC deducted that amount from EBITA, affecting the earn-out. The plaintiffs argued, and the court agreed, that nothing in the provision stated that the remedy for an R&D shortfall was an adjustment to EBITA. ABC's only remedy - which it had not pursued here - would be to sue "appropriate defendants" for the shortfall. Because the earn-out rose exponentially (more or less) as EBITA increased, restoring the $1.25 million to the EBITA increased the potential earn-out by far more than that amount.
Failing to distinguish between an "average" and a "weighted average" cost ABC even more dearly. The crucial paragraph 34 of Annex I of the merger agreement provided:
When [Bridge's] products or services are bundled with other products or services of [ABC] or any of [ABC]'s other subsidiaries in a sale to a customer, [Bridge] will receive revenue credit for such bundled sale at [Bridge]'s list price for such products and services (less normal discounting of 20%; provided, however, that where products and services are discounted by more than 20%, the discount to be applied for purposes hereof shall be the average amount of the discount in the last (5) unbundled contracts executed prior to the execution of the subject contract) for determining Adjusted EBITA attainment each year for comparison to the Earnout Payment objectives of each year.
Discount rates in the comparison contracts ranged from 0 to 51.2%. ABC argued that "average" meant "weighted average" - the difference being an increase in the discount from 27.9% (unweighted) to 46.8% (weighted). While Chancellor Chandler agreed that a weighted average might make business sense, he saw no reason that an unweighted average might not also make business sense, as might a time-weighted average (with more recent contracts weighted more heavily) or any number of other conceivable formulas. ABC's lengthy argument on the "law of averages" - which ranged as far afield as Ty Cobb's batting average - failed to budge the court from its view that "absent explicit instruction to the contrary, the term 'average' implies a simple arithmetic mean".
Conflict with GAAP
Paragraph 34 of Annex I concluded as follows:
The credit for bundled sales will be added to revenues for determining Adjusted EBITA attainment in the year that the software is delivered to the customer and for services in the year in which the services are provided to the customer.
ABC argued that this had to be taken in the context of paragraph 4 of Annex I, which stated:
The term "Adjusted EBITA" means the earnings of the Surviving Corporation before interest, taxes and amortization, as determined in accordance with GAAP applied on a consistent basis, as adjusted pursuant to and in accordance with this Annex I...
Because GAAP precluded the attribution of the entire bundled sales credit to the year 2003, ABC argued, Adjusted EBITA had to be reduced accordingly. The court disagreed: the words "as adjusted pursuant to and in accordance with this Annex I" made it "perfectly explicit" that the adjustments in the Annex "took precedence over GAAP accounting". Chancellor Chandler went on to note that, had ABC wished to tie the bundled sales credit to principles of recognition under GAAP, "it would have been easy to draft such a contract".
The cost of bad drafting
All told, the cost of omitting the word "weighted", failing to make the sales credit calculation subject to GAAP recognition rules and failing to make R&D expenditure shortfalls count against EBITA was an upward adjustment to Adjusted EBITA of about $7.4 million, giving Bridge a positive Adjusted EBITA for 2003 of about $4.9 million. The earn-out, which ABC's negative EBITA calculation had set at $0, was accordingly increased by the revised EBITA calculation to the maximum amount the contract envisaged for 2003: $21 million.