When the prospects of an acquired business are uncertain, an earnout can bridge the valuation gap between buyer and seller and help get the deal done. Taking this route is not without risk, however, particularly where circumstances arise that aren’t clearly covered by the earnout language (and the longer the earnout period, the more likely circumstances are to change). In the first two cases discussed below, courts enforced the literal meaning of clearly-worded earnout provisions. In the third, however, an ambiguous earnout provision created uncertainty that the court could resolve only after an extensive review of the circumstances of the negotiations.
All three cases were decided under Delaware law by courts in the U.S., but given the relative lack of case law on these issues in Canadian courts and the reliance our courts place on U.S. law in those circumstances, the issues raised will be of interest to anyone involved in the negotiation and drafting of earnouts.
Summary
- In Retail Pipeline v. Blue Yonder, the court rejected the seller’s attempt to invoke Delaware’s implied covenant of good faith and fair dealing against a purchaser that had made a business decision to conduct its affairs in a way that failed to maximize the seller’s earnout.
- In Shareholder Representative Services v. HPI Holdings, the seller argued that it deserved earnout payments that the agreement had made contingent on the buyer’s signing a “new agreement” with a prior customer of the seller. The court, noting that the purported “new agreement” was just the old agreement with a few riders attached, held that an agreement is not “new” if it is contingent on an existing agreement.
- In Fortis Partners v. Dematic, the earnout amount was tied to sales of the seller’s “company products”. This term was only vaguely defined in the agreement and the court found that it was ambiguous. After considering the surrounding circumstances, the court accepted the seller’s view that “company products” included software developed after the merger that made use of the seller’s purchased source code.
1. Limits of the Good Faith and Fair Dealing Doctrine
Delaware’s implied covenant of good faith and fair dealing (which is similar to the doctrine of good faith performance under Canadian law) cannot generally be invoked against an acquiror that conducted its post-acquisition business in a manner that failed to maximize the seller’s earnout. In affirming a lower court ruling, the U.S. Court of Appeals for the Second Circuit stressed that the obligations of parties with respect to earnout agreements will generally be limited to what has been set down in writing.
The transaction
Retail Pipeline, LLC v. Blue Yonder, Inc., arose from the 2014 sale of the appellant company’s (“Seller”) principal asset – the IP rights in supply chain software that it had developed – to the respondent company (“Purchaser”). Under the terms of the Purchase Agreement, Seller transferred its interest in the IP to Purchaser in return for an up-front payment of $3 million plus an earnout of up to $7 million.
The earnout
The earnout was calculated in reference to amounts (above specified thresholds) generated by three revenue streams. One of the streams was described as licensing revenue from “Flowcasting 2.0 or similar product”, a reference to a projected “2.0” version of the seller’s software. Purchaser’s future development of the 2.0 version had been discussed by the parties, but the agreement did not go into detail about what “Flowcasting 2.0 or similar product” meant, nor did it expressly impose an obligation on Purchaser to develop, or even to employ its best efforts to develop, such a product.
As it turned out, Purchaser did not develop the Flowcasting 2.0 (or similar) product and – presumably partly as a result – the earnout to be paid was only $980,000.
Seller’s allegations
Seller brought proceedings in the U.S. District Court for the District of Vermont alleging:
- Breach of contract, on the basis that the unclear meaning of “Flowcasting 2.0 or similar product” created an ambiguity that could only be resolved by extrinsic evidence which would in turn show that there was an obligation to use best efforts to develop the product; and
- Breach of the implied covenant of good faith and fair dealing, on the basis that Purchaser’s failure to develop the “2.0” product had unreasonably deprived Seller of the fruits of its bargain.
Key issues on seller’s motion for summary judgment
Purchaser moved successfully for summary judgment, a decision that the Second Circuit upheld in this unpublished (and thus non-precedential) opinion.
Breach of contract
The breach of contract claim was quickly disposed of. Delaware law, which governed this contract, permits reference to extrinsic evidence to resolve contractual ambiguities (this also comes up in the Fortis Advisors decision, below). The Court held, however, that an ambiguity in the description of the product could not be used, as the Seller seems to have been attempting to use it, as an excuse to bring in extrinsic evidence relating to an obligation to produce the product that is “found nowhere in the [written agreement].”
Breach of the implied good faith duty
The good faith claim, while possibly more plausible, was equally unsuccessful. With respect to earnouts, Delaware’s implied “good faith and fair dealing” covenant may be breached if a purchaser acts with the intention of depriving the seller of its earnout payments. An example would be where a purchaser diverts sales from the acquired entity to another division of the company whose revenues are not factored into the earnout (Winshall v. Viacom International, Inc., 76 A.3d 808, 811 (Del. 2013); American Capital Acquisition Partners, LLC v. LPL Holdings, Inc., 2014 WL 354496 at 6-7 (Del. Ch.)). In spite of this, as a general principle, the implied covenant does not require a purchaser to run its business “so as to ensure or maximize the [seller’s] earn-out payments” (Winshall, 811).
While Seller was able to produce an email suggesting that Purchaser had assured it that it would integrate Flowcasting features into its new products, Seller’s proposal during negotiations that language to this effect be included in the contract had been rejected by Purchaser. Under Delaware law, the implied term cannot be used to revive a provision that was rejected at the bargaining table.
Breach of the purchaser’s reasonable expectations
Seller’s final argument was that Purchaser had deliberately thwarted its reasonable expectations with respect to the earnout. As far as the Court was concerned, however, Purchaser had simply chosen to focus its business activities in areas that happened not to enhance Seller’s earnout. There was no evidence that this action had been taken to undermine the earnout payment.
Conclusion
The motion judge’s decision to grant summary judgment to the Purchaser was accordingly upheld.
See our 2015 article on good faith performance in earnouts and our recent post on the Ontario Court of Appeal ruling in Bhatnagar v. Cresco Labs for a Canadian perspective on this issue.
2. Everything Old Isn’t New Again: Earnout Provision Means What It Says
This Delaware Court of Chancery summary dismissal ruling held the selling stockholders (“Selling Stockholders”) to the clear terms of an earnout agreement, rejecting their claim that the purchaser’s failure to pay out the $6 million contemplated in the agreement was a breach of contract. Purchaser’s motion to dismiss the claim for failure to state a claim upon which relief can be granted, under Court of Chancery Rule 12(b)(6), was granted.
The transaction
The dispute arose out of the 2021 merger of two U.S. healthcare businesses. The acquired company, AdvantEdge Healthcare Solutions, Inc. (“AHS”) was the survivor in the merger. The Selling Stockholders sold their stock to the defendant HPI Holdings, LLC (“HPI”), parent of the merged entity.
The earnout
The earnout included a $6 million payment if an agreement with BPA (a key customer of AHS before closing that had terminated its service agreement) of one of the following three types was entered into after closing:
- A new agreement with any [subsidiary of AHS] or an affiliate of [HPI] with substantially the same economic terms as [AHS’s] existing agreement with BPA but without the early termination clause contained therein;
- An amendment to [AHS’s] existing agreement with BPA that removed the early termination clause contained therein; or
- A new agreement with any [subsidiary of AHS] or Affiliate of [HPI] satisfactory to [HPI] in its sole discretion after the Closing.
On December 22, 2021, BPA and the post-merger AHS did in fact come to terms. The “new” agreement (“December Agreement”) consisted of a copy of the old agreement with an attached page of riders titled “Agreement to Amend Service Agreement”. Among other things, the new provisions suspended BPA’s existing right to terminate on 90 days’ notice until September 30, 2022, which effectively precluded early termination for about one year.
The following day, the CEO of AHS wrote a letter to HPI stating that the December Agreement triggered the $6 million earnout as it constituted a “new agreement” that was “satisfactory to HPI” and thus met condition (3) above.
Selling Shareholders’ allegations
The situation escalated quickly and on February 18, 2022 the Selling Shareholders initiated this breach of contract action (in which the Selling Stockholders added an “in the alternative” argument that the earnout was also triggered under condition (2) in virtue of the change to BPA’s termination rights). HPI moved to dismiss on a number of grounds which were eventually reduced to one: a failure to state a claim on which relief can be granted.
Was the December Agreement an amendment or a new agreement?
Selling Shareholders’ first argument, that the earnout had been triggered under condition (3), was denied by HPI on the ground that the December Agreement was not “new”. Delaware follows the “objective” theory of contracts: a contract means what an objective, reasonable third party would believe it to mean. If there is an ambiguity, it must, for the purposes of a motion to dismiss, be read in favour of the non-moving party. In this case, the Court held, there was no ambiguity: HPI’s interpretation of the contract was the only reasonable interpretation. The December Agreement did not constitute a new agreement under condition (3). It was an “amendment” (repeatedly referred to as such in the text) that had been entered into as contemplated in the original BPA agreement and, by definition “an amendment requires that the thing being amended continue to exist.” As the Court also put it, “a new agreement is not contingent on the presence of an existing agreement”. The fact that the December Agreement added a few “material new terms” to the original BPA agreement did not make it new.
The Court added that, had the above not been clear as a matter of law, it would have been clear from the distinction that the December Agreement itself makes between an “amendment” (in (2)) and a “new agreement” (in (1) and (3)).
Was the early termination clause “removed”?
Selling Shareholders’ alternative argument, that the earnout had been triggered under condition (2) because the December Agreement had removed the early termination clause, was quickly dispensed with by the Court. As noted above, the December Agreement included a provision that effectively suspended the 90-day termination right for about a year. Selling Shareholders argued that this provision “entirely supplants” the old one. The Court held that the new provision “unambiguously supplements, rather than supplants” the old provision. It took a very literal view in doing so, insisting that “to remove” is not ambiguous and means “to eliminate, to delete, or to take out”. The December Agreement did none of those things: it merely “delayed BPA’s ability to exercise its early termination right”.
It might be asked how far the Court would have taken this line of reasoning – e.g. if the delay had been for 10 years or some other period that made the right ineffectual. But clearly one year was not enough.
Conclusion
The motion to dismiss the earnout claim under Court of Chancery Rule 12(b)(6) was therefore granted.
3. Provision Tying Earnout to Sales of Target’s “Products” Includes New Products That Use Blocks of Target’s Source Code
In contrast with the other two cases, this Delaware decision illustrates what can happen when key terms of an earnout agreement are not clearly defined. The dispute in Fortis Advisors v. Dematic revolved around the meaning of the term “product”, particularly whether the selling company’s “products” included source code that purchaser used in applications that it developed after the merger. The value of the earnout was tied to post-merger sales of the seller’s products, but the purchaser did not include sales of new products containing the seller’s old source code in its earnout calculations. The selling shareholders objected and eventually sued. After resolving the ambiguity by examining the surrounding circumstances, the Court agreed that the code was a “product” that counts toward the earnout.
The transaction
In 2015, Dematic Corp. (“DC”) acquired Reddwerks Corp. (“RC”) in a share purchase deal. DC is a multinational engineering and supply-chain logistics company, while RC created and installed hardware and software products supporting supply-chain logistics and distribution systems. The terms of the deal were $45 million up-front (less a few expenses) plus an earnout over a 14-month post-merger period.
The earnout
The earnout had two elements: a scaled EBITDA adjustment that topped out at $3 million and a potentially much larger “Earn-Out Merger Consideration” (“EOMC”) element, under which Reddworks’ selling shareholders would receive an additional payment of up to $10 million “based upon the Order Intake Amount (“OIA”) achieved during the 14-month period”. EOMC kicked in when OIA exceeded $36 million and increased, on a straight-line basis, to the $10 million maximum when OIA hit $48 million.
“Company Products”: the key concept
OIA was defined as the amount paid for all “Company Products”, which was in turn defined by reference to Disclosure Schedules that itemized the RC products that were “currently distributed or offered to third parties”, many of which were “functionalities” described in just one or two words. This reflected the fact that (as the Court put it) RC was selling “intangible functionalities” consisting of “lines of source code that a computer reads to provide the functionality” rather than off-the-shelf software solutions that integrate a suite of functions into a packaged product.
Despite their focus on functionalities, the Disclosure Schedules referenced in the “Company Products” definition did not expressly mention “source code”.
Representations and covenants by the Purchaser in relation to the Earnout
The $36-48 million earnout target range was considerably above RC’s pre-merger revenues, but certain representations by DC, set down in the Merger Agreement, appeared to make it realistic. In particular, DC:
- “acknowledged” that its 2016-2018 strategic plan would target orders for the sale of Company Products exceeding the earnout thresholds;
- agreed to incentivize its sales force to sell Company Products; and
- agreed that its engineers would integrate Company Products into its products and services.
Despite the above representations, DC in the Merger Agreement “disclaimed any liability for any claim based on the methods or strategies [that it] used or [did not use] after closing”. Importantly, however, it did agree in the Merger Agreement to use “commercially reasonable efforts” to track and account for the above.
Post-merger reality
The reality, the Court found, was quite different. DC did not incentivize its sales force and did not develop a strategic plan for the period in question at all. While it did integrate some blocks of RC’s code into software products that it developed and sold after the merger, it did not treat sales of this “integrated” software as sales of “Company Products” for earnout purposes, nor did it appear to have adequately tracked such sales.
DC calculated OIA in 2017 as $37.9 million. This generated just over $1.5 million of EOMC, all of which DC set off against certain litigation expenses and dissenter payouts. Fortis – the selling shareholders’ representative and formal plaintiff in the action – took issue with the calculation and sued DC, alleging (i) failure to incentivize its sales force and (ii) failure to include integrated Company Products in the earnout calculations.
Key issues at trial
When is software a “Company Product”?
The definition of “Company Products” in the Merger Agreement consisted mainly of a reference to a schedule that listed RC products using non-technical “shorthand”. Because these one- and two-word descriptions were imprecise and unclear, “Company Products” was (in the Court’s view) “susceptible of different interpretations or … different meanings”. Resolving the ambiguity required the Court to consider extrinsic evidence. It found that the parties understood that the essence of RC’s business was the production of “modules” – blocks of code that execute specific functions – and that, after the merger, DC had integrated RC functionalities into its products by integrating RC source code into them. The court reasoned that, because those functionalities that RC sold “were entirely a function of its source code” and because the integration just described was expressly referred to in commitment (3) (see above), the best interpretation of “Company Products” encompassed RC’s source code.
It followed from this that post-merger products that incorporated RC source code had to be accounted for in the earnout calculation, which had not been done.
“Distributing” vs. “selling”
On a related point, the Court noted that “Company Products” were defined as “products currently distributed or offered to third parties” by RC. In the Court’s opinion, “distributing” or “offering” a product is not the same thing as “selling” it to a customer. In other words, while the customer might have been shopping for a functionality, rather than buying source code as such, when RC “sold” it that functionality it also “distributed” the source code. This sufficed to make the code a “Company Product”, potentially putting DC in breach when it sold products or services into which RC functionalities had been integrated without crediting the amount toward the earnout threshold.
The Court acknowledged that the Merger Agreement did not indicate how much source code must be integrated to make a product a Company Product, but in its view this was not enough to tilt the balance in favour of DC’s restrictive interpretation.
Conclusion
The decision was costly for DC. At an earlier stage of the proceedings, the Court had responded to certain shortcomings in DC’s disclosure by ruling that, if the RC source code was determined to be a “Company Product”, the selling shareholders (Fortis) would automatically be entitled to the maximum earnout – $10 million from the EOMC plus $3 million from the EBITDA adjustment, less some relatively small set-off amounts.
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