Friday, September 7, 2007
An earn-out obligates a buyer to pay additional acquisition consideration if the target, post-acquisition meets certain performance bench-marks. By permitting the buyer to agree to a seller's higher asking price but obtaining assurance that the value promised by the seller will still exist, earn-outs can thus be a valuable tool to resolve an impasse over price between a buyer and seller. But earn-outs have their own problems:
- The seller will request the buyer to agree to properly operate the business post-acquisition so the sellers have a greater chance of receiving the full earn-out. This will likely lead to the imposition of complex drafting restrictions and obligations put upon the operation of the business -- provisions which may hamper the buyer's ability to flexibly operate the business.
- If the business goes sour, charges by the sellers will inevitably arise that it is the result of poor decisions by the buyer and they are still entitled to the money -- these charges will undoubtedly find colorable support in some of the broad language typically included in the earn-out about using "reasonable best efforts" to operate and promote the business and other optimistic statements in the agreement.
- Things change -- earn-outs can go for several years, and the restrictions and other provisions governing the business may not provide for such events.
- The need to actually determine if the earn-out is fulfilled often results in pitched battles between the buyer and seller and charges of accounting manipulation. M&A lawyers therefore have to be very careful to highlight these difficulties to their clients, and attempt to negotiate provisions in earn-outs which either willfully address or otherwise omit covering these issues. All this without over-drafting and making the earn-out terms too complex. Earn-outs are a trap for the unwary.
All of this went through my mind as I read Chancellor Chandler's opinion issued earlier this week in LaPoint v. AmeriSourceBergen Corp., No. 327-C (Del. Ch. Sept. 4, 2007). In LaPoint, AmerisourceBergen had agreed to acquire Bridge Medical Inc. for an initial payment of $27 million dollars, and further agreed to an "earn-out” to be paid to former Bridge shareholders contingent upon certain EBITA [earnings before interest, tax and amortization] targets being met over a two year period. The earn-out payment varied between $55 million and zero, depending on the EBITA of Bridge achieved in each of those years. Chandler describes the dispute as thus:
This case falls into an archetypal pattern of doomed corporate romances. Two companies Bridge Medical, Inc. and AmerisourceBergen Corporation—agree to merge, each convinced of a happy future filled with profits and growth. Although both partners harbor some initial misgivings, the merger agreement reflects these concerns, if at all, in an inaccurate and imprecise manner. After some time, the initial romance fades, the relationship consequently sours, and both parties find themselves before the Court loudly disputing what the merger agreement “really meant” back in its halcyon days.
If this case is different, it is only in the speed with which the ardor faded. Both parties now assert that mere months after the ink on the merger agreement had dried, if not before, their erstwhile paramour had determined that the relationship was not worth the candle. Plaintiffs (former shareholders of Bridge) insist that defendant provided lukewarm support for their operations and did everything possible to avoid having to pay merger consideration contingent on the success of plaintiffs’ former firm. Defendant blames plaintiffs’ woes upon plaintiffs’ lack of long-term planning, inconsistency between plaintiffs’ strategies and actions, and an inability to cope with market changes. Plaintiffs now seek damages in response to defendant’s alleged breaches of contract.
The first charge leveled by the plaintiffs was breach of the earn-out provisions in the acquisition agreement due to ABC's promotion of other competing products, changes to Bridge's publicity policy and general failure to actively and exclusively promote Bridge products. Importantly. ABC had agreed to the following provision in the agreement:
[ABC] will act in good faith during the Earnout Period and will not undertake any actions during the Earnout Period any purpose of which is to impede the ability of the [Bridge] Stockholders to earn the Earnout Payments.
ABC had also agreed in the agreement to "actively and exclusively" promote Bridges products. Chandler ultimately found that "ABC frequently and intentionally breached its duty to provide active and exclusive support for Bridge sales efforts," but since it did not affect the business's failure to meet the earn-out targets only nominal damages of six cents were appropriate. Nonetheless, Chandler ordered ABC to pay plaintiffs $21 million arising from ABC's miscalculations of the earn-out. Here, plaintiffs had charged that ABC had intentionally miscalculated the earn-out appropriate for 2003 by giving too high a discount on a significant sale, making too big an adjustment to EBITA to account for R&D expenditures and postponing recognition of another significant sale. ABC has announced they will appeal. Given the deference provided the Chancery Court by the Delaware Supreme Court and the fact-based nature of Chandler's determination, I'm not sure it is worth their money. Again, earn-outs can be helpful in achieving a deal, but they are a trap for the unwary.