Sale of Buyer’s Equity Provides “Good Faith” Justification for Not Earning Earnout
As we have written about in the past, earnout provisions in M&A agreements are often ways to find value and bridge a buyer’s and seller’s differing expectations of the future. But they also are ripe for litigation, especially if the buyer changes the way the business is run or pursues other opportunities that may affect the earnout. Such disputes are highly fact-specific and often turn on the unique issues facing the acquired business. A recent case from the Delaware Court of Chancery illustrates an example of a buyer not having to pay an earnout when its conduct to not enter into new business with a potential customer was influenced by a simultaneous transaction to sell an equity stake in the buyer.
A. The Earnout and New Transaction of Buyer’s Equity
The seller of a data management business, STX Business Solutions LLC (“Seller”), sued the buyer, Financial-Information-Technologies (“Buyer”) and its parent company for breach of contract, breach of the implied covenant of good faith and fair dealing, tortious interference with contract against the parent, and fraudulent inducement. Seller alleged that Buyer intentionally took actions to prevent the earnout from being earned by refusing to pursue a lucrative contract with a major customer and structuring a later transaction with a new investor to avoid triggering the maximum earnout. The court found that the transaction with the new investor explained the Buyer’s rationale for not entering into the lucrative contract, and was itself permitted by the purchase agreement.
The earnout provision provided Seller additional consideration if specified revenue goals were met, with a maximum earnout of $5.5 million. Buyer was prohibited from acting in “bad faith” or with “specific intention” of reducing the earnout. The court said this provision was buyer-friendly, and contrasted it with provisions that required the Buyer to “use best efforts, commercially reasonable efforts, or even good faith efforts to achieve the Earnout.” Additionally, as is common, the purchase agreement envisioned that there may be later transactions (like the later sale of the company) that would impact the earnout. The maximum earnout would be due and payable upon a “Sale of the Company,” which was defined in relevant part to mean the acquisition of a controlling equity stake in the Buyer by a new party.
Before the transaction, Seller pursued (but never obtained) a contract with a major customer. Two years after the transaction with Buyer closed, that customer invited Buyer to submit a proposal and stated that Buyer’s products appeared to be the only viable ones for the customer’s needs. Buyer initially indicated that it would be bidding, and Seller thought this meant that the earnout would be earned. But, at the last minute, Buyer declined, ultimately because it was pursuing a transaction to sell equity in the Buyer to a new investor, and was worried the new contract might “muddy the waters” of that transaction. Shortly thereafter, the sale to the new investor concluded, not with the sale of control, but rather with a new entity owning a 48.1% voting stake, which now matched the voting stake of the Buyer’s prior 100% parent.
Seller sued. The defendants moved to dismiss, which the court granted. The court refused to infer a breach of the earnout provision where a reasonable business judgment existed for not entering into the new business. The court found that Buyer had a legitimate business reason to decline the opportunity, i.e., that it could complicate the transaction with the new investor.
The court also found that the transaction with the new investor (one of shared control rather than a sale of control) was specifically envisioned by the purchase agreement. The purchase agreement only required the earnout to be paid when a new party obtained control. But in this case, the new party did not obtain control; it obtained an equal share of the voting power. Thus, the court found that this transaction did not trigger the earnout provision.
Nor was Buyer’s conduct a breach of the implied covenant of good faith and fair dealing. As the court stated, “[t]he parties could have drafted a trigger based on [new owner’s] loss of sole control, but they did not do that. The Agreement clearly states that the Maximum Earnout will become due and payable upon a Sale of the Company. The necessary implication is that other types of transactions do not trigger the Maximum Earnout. Once again, there is no gap for the implied covenant to fill.”
Finally, the court dismissed Seller’s claims against Buyer’s parent company for tortious interference and against Buyer for fraudulent inducement. The court found that “without an underlying breach of contract claim,” the claim for tortious interference must fail. The court also determined that the seller did not prove Buyer had an affirmative duty to disclose the negotiations with the new investors. Therefore, the fraudulent inducement claim failed too.
B. Major Takeaways and Implications
Deference to business judgment will not always defeat earnout claims and often not at the motion to dismiss stage. In this case, the fact that a sale of Buyer’s equity occurred shortly after the lost customer opportunity provided ample justification for the court to find that the Buyer did not act in bad faith when turning down the new customer opportunity. But that rationale will not apply to most situations and buyers will more often need to defend their actions with some alternative business rationale. That alternative business rationale is also more likely to require fact finding and is not susceptible to decision at a motion to dismiss. This also highlights the importance of the contractual standard agreed to govern post-merger conduct (here, “bad faith” or “specific intention” to interfere with the earnout, rather than a lesser standard).
Delaware courts will give strong deference to the contractual structuring of parties. Parties to earnouts often will specify a trigger under which the earnout will be paid if the buyer enters into certain transactions. This case shows that Delaware courts will strictly construe such trigger provisions, especially where they deal with common terms such as the sale of “control.” Sellers wishing to get the earnout upon such transactions should make sure they broadly capture all situations that they believe could impact the ability for the earnout to be earned.
This post is as of the posting date stated above. Sidley Austin LLP assumes no duty to update this post or post about any subsequent developments having a bearing on this post.
