Last year, the Delaware Supreme Court sided with a buyer who refused to pay $40 million in earn-out payments to the former owners of the target company. The Buyer had agreed to pay $80 million for the company--$40 million in cash at closing and $40 million in earn-outs contingent on the company reaching a target revenue figure by a certain time. However, after the sale, the buyer operated the company such that the Company missed the revenue target, saving the buyer from having to pay the $40 million earn-out. The seller sued, pointing to a provision in the operative agreement between the parties that prohibited the buyer from taking any action to divert or defer revenue with the intent of reducing or liming the earn-out. The seller claimed the buyer made business decisions he knew would have the effect of failing to meet the revenue target.
The court drew a distinction between the intent of the buyer and the knowledge of the buyer. In short, based on the language in the agreement, as long as the buyer could identify reasons for his business decisions that were not motivated by an effort to avoid the earn-out, the buyer would not run afoul of the prohibition against diverting or deferring revenue, even if he knew that missing the earn-out target was the probable consequence of his actions!To be clear, earn-outs are not always bad. They often serve as effective tools to align incentives among the seller and the buyer to ensure a smooth transition. Or they may be used to reconcile differences in the valuation of a company between an enthusiastic seller and a skeptical buyer. But as one Delaware judge has observed, “Earn-outs all too often transform current disagreements over price into future litigation over outcome.” Earn-outs shift risk onto the seller. Anyone who is selling a family business to a buyer that insists on an earn-out provision is encouraged to strategize with an attorney experienced with the technical and legal nuances of drafting and negotiating earn-out provisions. Omar Vasquez practices business, tax, and corporate law. He represents startups, emerging growth companies, and mature public and private entities in formations, financings, and mergers and acquisitions. Omar’s experience spans a breadth of industries, including technology, food and beverage, seafood, health care, and energy, in transactions ranging from $150,000 to $300 million in consideration. Omar can be reached via email at OmarVasquez@dwt.com or directly by phone at 206.757.8192.