In the realm of mergers and acquisitions, “earnouts” and other contingent purchase price provisions have increased in popularity, especially after the financial crunch of 2008. For those unfamiliar with the concept, an earnout is a mechanism used in an M&A transaction to assist buyers and sellers bridge valuation gaps over the business being sold in addition to allowing buyers to reduce downside exposure and rewarding sellers who deliver on aggressive pre-signing projections. When a transaction contains an earnout, payment of at least a portion of the purchase price is postponed until satisfaction of a performance metric sometime after closing. For example, an earnout provision within a purchase agreement may promise to pay seller a percentage of the gross margin provided the target company has achieved a certain amount of revenue at the end of each fiscal year for a certain period of time after closing of the transaction.
Unfortunately, while extremely popular, earnout arrangements are particularly difficult to negotiate and prone to future disputes. In negotiating an earnout provision, it is important to consider and attempt to deal with the multiple issues that may (and likely will) arise. However, no agreement can address every plausible future scenario and the race to close the transaction often makes addressing every plausible issue impractical and so each party must choose its battles wisely.
One battle that often arises when negotiating the earnout provision of an M&A transaction is whether the buyer should agree to a covenant that, to some extent, will govern its operation of the business post-closing. From the seller’s viewpoint, the buyer should agree to operate the business consistently with how the seller operated it before the closing, maintain separate records for the business and make its best efforts to achieve the payment milestones. Naturally, the buyer would want to take the exact opposite approach and disclaim any obligation to operate the business in any particular way. Frequently, no post-closing covenant language exists regarding operation of the business by the buyer which usually benefits the buyer. However, relatively new case law in Delaware issued earlier this year may dictate how the parties behave post-closing if the purchase agreement is subject to Delaware law.
In American Capital Acquisition Partners, LLC v. LPL Holdings, Inc., CA NO 9490-VCG, 2014 WL 354496 (Del. Ch. Feb. 3, 2014), American Capital Acquisition Partners (ACAP), sold its subsidiary, Concord Capital Partners, Inc. (Concord), a provider of investment management solutions, to LPL Financial LLC (LPL), a provider of investment advisory services. ACAP and LPL entered into a stock purchase agreement that included an earnout provision under which LPL was obligated to pay ACAP additional compensation if Concord met certain revenue targets post-closing; no post-closing covenants existed within the stock purchase agreement obligating the buyer to conduct Concord’s business in a certain way. ACAP alleged, among other things, that LPL intentionally conspired to divert clients, personnel and opportunities from Concord to another LPL division, which affected Concord’s opportunity to meet the earnout revenue targets. ACAP sued LPL for, among other things, breach of the implied covenant of good faith and fair dealing.
LPL moved to dismiss the complaint in its entirety. The court granted LPL’s motion in part and denied in part. In relevant part, the court denied LPL’s motion as to ACAP’s claim that LPL breached the implied covenant of good faith and fair dealing by steering sales from Concord to another subsidiary of LPL in order to avoid paying the earnout compensation. The court held that the implied covenant serves as a “gap-filling” function and may apply where the parties’ contract is incomplete and does not reflect their reasonable expectation at the time of contracting. In this particular case, the court found that the earnout provision demonstrated that, had the parties contemplated that LPL might have actively tried to steer sales away from Concord to avoid paying the earnout compensation, the parties would have contracted to prevent such behavior and therefore it is appropriate to read the implied covenant of good faith and fair dealing into the stock purchase agreement.
This case, in addition to clarifying Delaware law on when the implied covenant of good faith and fair dealing may be invoked, serves as a cautionary tale as to the importance of understanding the parties’ post-closing obligations. Specifically, the case holds that, under Delaware law, while the implied covenant of good faith and fair dealing may prevent the buyer from taking actions to avoid or reduce an earnout payment, it doesn’t compel the buyer to take action to maximize such payment either and the parties should keep this in mind when negotiating earnout provisions and contemplating whether express covenants related to the earnout provision are appropriate.