When negotiations over the purchase price in a business acquisition hit an impasse, an earn-out may be a useful device to bridge the gap between the buyer and seller. Under an earn-out provision, a portion of the purchase price is paid post-closing based on the future performance of the acquired business. If the business achieves agreed targets, the seller is rewarded with additional compensation. On the other hand, the purchaser is protected from spending too much up front on a business that then falters in the first few years. A few bullet points on a term sheet under “earn-out” and problem solved - at least until it comes to negotiating the definitive agreement.
The devil is in the details with an earn-out. Who will run the business after closing? Will the purchaser make necessary investments in the business? How can the seller be assured that the purchaser will not divert opportunities to its other business units or acquire a competing business in the future? A seller needs reasonable guarantees regarding the operation of the business during the earn-out period, while the purchaser needs the flexibility and control to successfully manage its business. The challenge for counsel is how to achieve this without turning the purchase agreement into a tome that has to be consulted with every future management decision.
While it may not be practical to spell out every detail regarding the operation of an acquired business during the earn-out period, affirmative obligations that are necessary to make the earn-out targets achievable, such as investments by the purchaser to support and expand the business, should be addressed in the purchase agreement. The Delaware Court of Chancery emphasized this point in an opinion issued earlier this year in American Capital Acquisition Partners, LLC v. LPL Holdings.1
American Capital Acquisition Partners, LLC v. LPL Holdings
In American Capital Acquisition Partners, LLC v. LPL Holdings, the Delaware Court of Chancery dismissed claims that a purchaser breached its implied covenant of good faith and fair dealing by failing to make technical adaptations to its computer systems required to achieve the synergies necessary to meet earn-out targets under a stock purchase agreement. However, the court denied the purchaser’s motion to dismiss a claim that the purchaser breached the implied covenant by allegedly diverting the acquired company’s clients and employees to another subsidiary of the purchaser and discouraging clients and prospective clients from using the acquired company’s resources.2
In June 2011, LPL Holdings, Inc. (LPL), a Massachusetts corporation focused on providing technology, brokerage and investment advisory services to financial advisors, acquired Concord Capital Partners, Inc. (Concord), a subsidiary of American Capital Acquisition Partners, LLC (American Capital) that specialized in providing services to trust departments of financial institutions.3 The stock purchase agreement governing the transaction included an earn-out provision that called for additional purchase price payments based on the future success of the acquired business.4 In connection with the acquisition, LPL also entered into employment agreements with several officers and directors of Concord that contained bonus provisions contingent on Concord’s future performance.5 When LPL refused to make the earn-out and bonus payments due to Concord’s failure to achieve the projected targets, American Capital and the former officers and directors of Concord brought claims against LPL, asserting among other matters, that LPL breached its implied covenant of good faith and fair dealing.6
According to American Capital, it elected to pursue a transaction with LPL based in part on the expectation that LPL’s acquisition of Concord would enable Concord to develop a custody services business for its trust accounts.7 American Capital’s complaint asserted that it and the other plaintiffs rejected a competing acquisition offer that proposed a greater initial cash payment and a potentially greater overall sale price from a potential purchaser that did not perform custody services, because an acquisition by a company such as LPL that performed custody services would generate significant synergies.8
Prior to closing, executives from Concord met with LPL’s CEO, the managing director of its technology group and other members of LPL’s management team to discuss issues of potential concern regarding any technical limitations in LPL’s computer system, including possible problems relating to LPL’s custody of trust assets.9 American Capital’s complaint specifically noted that the parties anticipated that LPL’s computer system would require some technical adaptation.10 American Capital asserted that LPL assured it that LPL would make any necessary ministerial technical changes to its computer system, and claimed that LPL’s public and private statements regarding its technical capabilities concealed the serious difficulties of integrating Concord into the LPL system.11 According to American Capital, after the closing LPL refused to customize its system to allow LPL to provide custody services to Concord, and consequently, Concord was unable generate revenue it could have generated prior to its acquisition by LPL, or if the technological changes had been made. 12
American Capital argued that the implied covenant of good faith and fair dealing imposed on LPL an obligation to make the technological adaptations necessary to enable LPL to provide custody services to Concord.13 The court pointed out in the opinion, however, that although the parties anticipated that LPL’s systems would require some changes, they did not include any provision in the purchase agreement obligating LPL to make any technical adaptations necessary to allow Concord to develop its custody business after closing.14
The court stated in the opinion that “the implied covenant of good faith and fair dealing, as the Plaintiffs recognize, serves a gap-filling function by creating obligations only where the parties to the contract did not anticipate some contingency, and had they thought of it, the parties would have agreed at the time of contracting to create that obligation.”15 The court dismissed this portion of the implied covenant claim because American Capital “anticipated, but failed to bargain for, a requirement that [LPL] adapt their software and data-handling capabilities.”16
The court, however, denied LPL’s motion to dismiss American Capital’s claim that LPL breached the implied covenant of good faith and fair dealing by shifting employees and customers from Concord to Fortigent, another LPL subsidiary, in order to avoid earn-out payments.17 According to American Capital, Concord’s staff was told to discourage prospective clients and current clients from using Concord’s services and to “stand down” with existing clients and some Concord employees were transferred to Fortigent.18
The court found that taken together, the contingent purchase price provision in the stock purchase agreement, the compensation targets in the employment agreements with Concord’s former directors and officers, and the section of the stock purchase agreement that provided for the calculation of revenue for the purposes of the earn-out targets “demonstrate that, had the parties contemplated that [LPL] might affirmatively act to gut [Concord] to minimize payments under the [purchase agreement] and employment agreements, the parties would have contracted to prevent LPL from shifting revenue from [Concord] to Fortigent.”19
Rubin Squared, Inc. v. Cambrex Corporation
The United States District Court for the Southern District of New York reached a similar conclusion in Rubin Squared, Inc. v. Cambrex Corporation,20 applying Maryland law in an analysis of the implied covenant of good faith and fair dealing in connection with an earn-out in an asset purchase transaction.
The plaintiff in that case, Rubin Squared, Inc. (Rubin Squared), claimed, among other allegations, that the defendant, Cambrex Corporation (Cambrex), breached the asset purchase agreement that it entered into with Rubin Squared’s predecessor corporation Bio Science Contract Production Corp. (Bio Science), by violating the implied covenant of good faith and fair dealing. The asset purchase agreement for the purchase of the Bio Science business contained a provision for earn-out payments over four years based on Bio Science’s annual earnings.21 During the negotiation of the asset purchase agreement, Bio Science’s president, an experienced lawyer, proposed changes to the draft earn-out provision, including clauses rejected by Cambrex that would have obligated Cambrex to provide the reasonably necessary management, financial and operational resources and support to achieve Bio Science’s strategic and growth plans, and a provision that would have prevented Bio Science from acquiring a competing business.22
Rubin Squared claimed that during the negotiations, Cambrex made oral representations to Bio Science that it would fund a $60 million expansion of Bio Science’s facilities, that during the earn-out period Bio Science’s principal, Jacques Rubin, would have full authority over Bio Science’s operations, that Cambrex was not considering acquiring any competitor to Bio Science, and that Cambrex would make Jacques Rubin a corporate vice president of Cambrex and would not divert his efforts in a manner that would interfere with the achievement of the full earn-out.23
After completion of the acquisition, however, Jacques Rubin was not made a corporate vice president, Cambrex did not invest in an expanded facility for Bio Science, and Cambrex acquired Marathon, a competitor of Bio Science, and placed Jacques Rubin in charge of both Bio Science and Marathon.24
Rubin Squared argued that Cambrex violated its implied duty of good faith and fair dealing by failing to fulfill its pre-contractual promises and thus frustrating the achievement of the earn-out.25 The court rejected this argument, noting with respect to the anticipated facilities expansion that “the implied duty of good faith and fair dealing cannot possibly be understood to require that Defendant provide a $60 million facilities expansion when such a term was not included in the contract, particularly when language supporting such an obligation was expressly rejected by Defendant.”26
The court did, however, state that Rubin Squared’s assertion of bad faith relating to the acquisition of Marathon could have merit. The court found that the acquisition alone could not constitute a violation of the duty of good faith and fair dealing, as an earn-out provision does not inherently prohibit the purchaser from acquiring the target company’s competitors in the future. It also noted that Rubin Squared had attempted to negotiate a veto over future acquisitions, which was rejected. “Diversion of revenue to, or expenses from, Marathon would, by contrast, likely constitute bad faith,” according to the court.27 The court noted that it is “inherent in an agreement to share a percentage of a business unit’s earnings that the unit’s earnings will not be artificially diverted to another unit not covered by such profit-sharing obligations.”28 The court granted Cambrex’s motion to dismiss the claim, however, because Rubin Squared had not presented any evidence of diversion of revenue by Cambrex.
More is Sometimes More in Drafting an Earn-Out
As American Capital Acquisition Partners, LLC v. LPL Holdings and Rubin Squared, Inc. v. Cambrex Corporation demonstrate, courts are reluctant to read obligations into an earn-out clause where the parties have failed to address previously identified issues through specific covenants in the purchase agreement. On the other hand, courts are less tolerant of actions by a purchaser that demonstrate an attempt to divert resources, opportunities or revenue away from an acquired company to avoid paying an earn-out.
Although it is impractical to try to anticipate and draft for every contingency that may impact an earn-out, counsel should review business plans and participate in discussions between the parties regarding the post-closing operation of the business. At a minimum, any anticipated post-closing investments from the purchaser that are necessary to achieve expected synergies or earn-out targets should be memorialized in the purchase agreement. In addition, if the purchaser has many different business units or is likely to make future acquisitions, affirmative covenants regarding conflicts or allocation of resources should also be considered.