Summary
An earnout is a contractual provision in an agreement for the purchase and sale of a business in which the Seller’s receipt of payment is contingent upon or varies with achievement of certain business goals, such as revenue or profitability targets (a sample is available under “the Earnout Provision,” below).
Under Delaware Law, the Implied Covenant of Good Faith and Fair Dealing (Implied Covenant) prohibits the Buyer of a business from purposefully interfering with the Seller’s earnout. However, the Implied Covenant does not, in itself, obligate a Buyer to create conditions for a Seller to receive an earnout if those conditions did not already exist.
Case Description
American Capital Acquisition Partners, LLC v. LPL Holdings, Inc. 2014 WL 354496 (Del. Ch. Feb. 3, 2014).
- Facts: On April 20, 2011, LPL Financial LLC (Buyer) purchased 100% of the equity of Concord Capital Partners, Inc. (Target), a subsidiary of American Capital Acquisition Partners, LLC (Seller). In addition to a specified purchase price, the Stock Purchase Agreement included an earnout provision in which payment was contingent on achieving gross margin targets, as follows (the Earnout):
The Earnout Provision:
In addition to the Closing Purchase Price payable at Closing, and subject to the terms and conditions set forth in this Section 2.06, [Seller] shall be entitled to an additional purchase price payment from [LPL] in an aggregate amount, if any (such aggregate purchase price payment is referred to herein as the “Contingent Purchase Price Payment ”) of (i) for every $250,000 in 2013 Gross Margin in excess of $5,500,000 but less than or equal to $7,250,000, $215,000 up to a maximum payment of $1,500,000 and (ii) for every $250,000 in 2013 Gross Margin in excess of $7,250,000, $675,000 up to a maximum payment of $13,500,000; provided, however, the maximum Contingent Purchase Price Payment shall not exceed $15,000,000.[1]
Achievement of the Earnout targets depended upon the Buyer’s ability to integrate its technology with the Target, which Seller was lead to believe would be a simple matter. However, the Stock Purchase Agreement did not include any obligation of the Buyer to integrate its technology with the Target, but it did include an “anti-reliance” clause in which stated that Seller was not relying on any representation or warranty other than those set forth in the Stock Purchase Agreement.
The Non-Reliance Provision:
Non–Reliance. Except for the representations and warranties by the Company in this Agreement, Buyer and Seller each acknowledge and agree that no Person is making, and Buyer nor Seller is not relying on, any representation or warranty of any kind or nature, express or implied, at law or in equity, or otherwise, in respect of the Company, the Business, the Sellers or the Buyer, including in respect of the Company’s Liabilities, operations, assets, results of operations or condition.[2]
After the acquisition, Seller realized that Buyer’s computer system could not be easily adapted to allow Seller to benefit from the synergies between Buyer and Target, which could significantly limit Seller’s ability to achieve the Earnout. At the same time, Seller claimed that Buyer began shifting employees and customers from the Target to the Buyer, allegedly hurting Seller’s ability to achieve the Earnout.
In an attempt to force Buyer to integrate the computer systems, Seller filed a lawsuit which claimed, among other things, that Buyer breached the Implied Covenant by: (1) failing to make the technical adaptations necessary for Seller to achieve the Earnout; and (2) shifting employees and customers away from Target, making the Earnout harder to achieve.
- Delaware Chancery Court’s Ruling: Buyer filed a motion to dismiss Seller’s claims, and in deciding the motion, the Delaware Chancery Court:
- Permitted Seller’s claim for breach of the Implied Covenant to continue based on Buyer shifting employees and customers away from Target because Seller alleged that Buyer had an obligation to avoid shifting resources away from Target in a way that hurt the Earnout.
However, the Chancery Court also
- Dismissed Seller’s separate claim for breach of the Implied Covenant which was based upon Buyer’s failure to integrate its technology with Seller, because the Stock Purchase Agreement did not contain any obligation for Buyer to integrate the systems, and Seller did not allege that the parties failed to anticipate the need for such integration (in fact, Seller explicitly alleged that the parties had discussed technical integration).
Takeaways
- The Implied Covenant of Good Faith and Fair Dealing “requires a party in a contractual relationship to refrain from arbitrary or unreasonable conduct which has the effect of preventing the other party to the contract from receiving the fruits of the bargain.”[3]
- “The covenant of good faith and fair dealing is implied in every contract,[4] and 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.”[5]
- If you are the Seller in an acquisition that includes an Earnout it is important to:
a. conduct due diligence on the Buyer to identify whether the Buyer has the ability and incentive to allow the earnout to be achieved; and
b. include language in the purchase agreement that gives the Buyer an obligation and incentives to achieve the earnout or at least create and maintain the conditions under which the earnout may reasonably be achieved.
[1] American Capital Acquisition Partners, LLC v. LPL Holdings, Inc. 2014 WL 354496 at 2 (Del. Ch. Feb. 3, 2014).
[2] Id. at *10
[3] Id. (quoting Dunlap v. State Farm Fire & Cas. Co., 878 A.2d 434, 442 (Del.2005)).
[4] Winshall v. Viacom Int’l, Inc., 55 A.3d 629, 636 (Del. Ch.2011).
[5] Winshall, 55 A.3d at 637.