Those of us involved in drafting M&A agreements spend a considerable amount of time vigilantly and artfully drafting certain contractual provisions to protect our client and ensure that our client receives the maximum rights and benefits negotiated in the agreement. In transactions that include an earn-out as part of the consideration package, the earn-out provision is an example of one such provision. Earn-outs are often crafted with painstaking detail in an effort to ensure that all possible scenarios are dealt with and that very little is left for interpretation by an outside third party, such as a court or arbitrator. Nevertheless, disputes relating to the implementation and interpretation of earn-out provisions often lead to court cases. The decisions that emanate from these cases are then reviewed and studied in an attempt to avoid future earn-out disputes. However, as is too often the case, lessons are not learned and history repeats itself in the form of continued earn-out disputes.
Two recent decisions provided by the Delaware Chancery Court attempt to provide further clarity on issues commonly at the center of earn-out disputes.
Earn-outs are utilized to bridge the valuation gap between a buyer and a seller and are often used in cases where the seller is exceedingly optimistic about, and the buyer maintains a healthy skepticism regarding, the future profitability and performance of the business.
Fortis Advisors LLC v. Dialog Semiconductor PLC involved a dispute over whether the selling equity holders of iWatt, Inc., were owed earn-out payments resulting from a sale of their company to Dialog Semiconductor PLC. The issue at hand was whether a plaintiff is permitted to assert in an earn-out dispute a claim for breach of the implied covenant of good faith and fair dealing as an alternative to a breach of contract claim in case the breach of contract claim is later rejected.
The merger agreement governed by Delaware law contained an earn-out provision pursuant to which earn-out payments would be triggered if certain revenue thresholds were met within prescribed time periods after the closing. As part of the earn-out, the parties agreed to certain restrictions on Dialog’s ability to manage the business post-closing, including an agreement to use commercially reasonable efforts to achieve and pay the earn-out payments. The merger agreement also included a number of specific obligations and prohibitions on Dialog in connection with its operation of the business during the earn-out period.
Dialog notified the sellers that the business did not achieve the applicable revenue targets and therefore no earn-out payments would be made. The sellers contested this notion and eventually the case made its way to the Delaware court. In the court’s ruling, the court acknowledged that under Delaware law the implied covenant of good faith and fair dealing attaches to every contract by operation of law and requires each party to refrain from arbitrary or unreasonable conduct in an effort to prevent the other party from receiving “the fruits of the bargain.” However, in cases where the contract speaks directly regarding the issue in dispute, the existing contract terms control and the implied covenant of good faith and fair dealing is not to be used to circumvent the negotiated and agreed-upon terms and intent of the parties. In other words, the covenant of good faith and fair dealing only applies if the applicable contract lacks specific language governing the issue at hand.
In the face of that underlying legal analysis and the fact that the merger agreement expressly imposed on Dialog the obligation to use commercially reasonable best efforts to achieve and pay the earn-out, the court rejected the sellers’ assertion that the implied covenant of good faith and fair dealing could be used as an alternative theory for recoupment of the earn-out payments.
In Weiner v. Milliken Design, Inc., the sellers and buyer had negotiated and executed a stock purchase agreement that contained an earn-out based on future revenue. The agreement provided that any dispute with respect to the earn-out provision that could not be resolved by the parties themselves would be submitted to arbitration. In the midst of a subsequent earn-out dispute, one of the parties asked the court to rule on certain issues relating to the interpretation of the earn-out provision. However, because the court felt that the purchase agreement clearly and unambiguously demonstrated the parties’ intent to arbitrate earn-out disputes, the court declined to rule on the earn-out-related matters.
Both cases correctly defer to the bargained intent of the parties and prohibit a party from later attempting to circumvent this intent. Unfortunately, there are far too many examples of cases where a party presents an “alternative theory” or evidence that purports to negate the otherwise clear meaning of the parties’ bargain. But these two cases demonstrate the disdain for such an approach and provide an illustration of the rewards of explicitly (and sometimes painstakingly) crafting detailed earn-out provisions.