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Boston College Law School

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Tuesday, January 12, 2010

Just Say No – to Earnouts

Here’s another reason to just say no to earnouts –Sonoran Scanners v PerkinElmer.  Plaintiff Sonoran argued that notwithstanding the lack “reasonable efforts” language in the asset purchase agreement that there should be an implied obligation to exert reasonable efforts in an earnout provision.  A federal appellate court in Massachusetts agreed with that argument in a recent appeal from summary judgment when it held that under Massachusetts law, there is such an implied obligation in an earnout  provision.

In the transaction, PerkinElmer purchased substantially all the assets of privately-held Sonoran Scanner for $3.5 million plus an earnout of up to $3.5 million.  Given Sonoran’s already weakened financial state, a significant portion of the initial $3.5 million was paid to Sonoran’s creditors and not to its shareholders.  Shareholders were to be paid on the back end. Under the terms of the earn-out provisions, PerkinElmer would pay Sonoran $750,000 if at least three of Sonoran Scanner’s CTP machines were sold in the first year following closing, $1.5 million (less any previously paid earn-out amounts) if at least ten machines were sold by the end of the second year, and additional earnout amounts if certain gross margin targets on sales of CTP machines were met.  The additional earnout payment (over and above the $1.5 million) during the five year payout period was a maximum of $2 million. 

The relevant earnout provision reads in part as follows:

 1.6 Earnout Adjustment

(a) The Base Purchase Price shall be subject to increase in the form of one or more payments, payable to the Seller subject to Section 7.2, as follows:

(i) If, on or before the first anniversary of the Closing Date, the Buyer has completed not less than a total of three Qualifying Product Sales (as defined below), the Buyer shall pay to the Seller, within ten business days of the first anniversary of the Closing Date, the sum of $750,000 (the "First Earnout Payment").  ...

(ii) If, on or before the second anniversary of the Closing Date, the Buyer has completed not less than a total of 10 Qualifying Product Sales (including any Qualifying Product Sales pursuant to Section 1.6(a)(i) above), the Buyer shall pay to the Seller, within ten business days of the second anniversary of the Closing Date, the sum of $1,500,000 minus the earnout amount, if any, paid to the Seller pursuant to Section 1.6(a)(i) above (the "Second Earnout Payment" ...

The way this provision is drafted, it's devoid of any language of obligation, relying solely on a conditional "if".  It's a poorly drafted earnout provision - one that almost begs to be litigated.  So, this case should be no surprise to anyone involved in the transaction. 

Notwithstanding the lack of obligatory language or specificity in the earnout provision, the appellate court, relying on MA precedent, read its conditional language to include an implied obligation of reasonable efforts.  The Massachusetts Supreme Judicial Court in Eno Sys, Inc. v Eno, (1942) held that it is implied that one who obtains the exclusive right to manufacture a product under a patent has “an implied obligation . . . to exert reasonable efforts to promote sales of the process and to establish, if reasonably possible, an extensive use of the invention.  The First Circuit reads that case to extend an implied obligation to exert reasonable efforts to an earnout provision where consideration to be paid is tied to a sales process.  

In this case, the fact that the asset purchase agreement makes some portion of the consideration contingent on back-end sales implies that the buyer will be required to exert reasonable efforts to make sales notwithstanding a lack of language in the agreement to the contrary.  For its part, PerkinElmer says it invested $2.5 million in a losing business over two years and then decided to exit the segment altogether.  PerkinElmer argued that even if it did have an implied obligation to expend reasonable efforts, it certainly did so. Whether it did or not, it's not really all that relevant this stage anymore.  It will be up to a trial court to decide whether PerkinElmer exert reasonable efforts before deciding to stop marketing the product after signing.

I'm pretty confident in assuming that the parties decided to go with an earnout as a way to "split the difference" during negotiations and come to a reasonably quick agreement rather than spend more time on valuation questions.  Consequently, they have this rather loose language that on its face does not seem to generate obligations on the side of the buyer but may leave the seller understanding something different.  In the end, the earnout becomes a deferred dispute provision.  Better just to spend the time up front on the valuation and avoid the earnout altogether.    

-bjmq

  

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Comments

I agree with your sentiments about earn-outs. As a Massachusetts lawyer, I would never want to litigate one here. This is a link to a client alert I just wrote about a similar earn-out dispute in Delaware http://tinyurl.com/yegg7gg.

Posted by: Michael Kendall | Jan 14, 2010 5:54:41 AM

Well, you have to say NO the earnouts when the shareholders don't know what they are doing...
In any firm, critical in technological firm, like Sonoran Scanners and PerkinElme, you have to get some consulting before this kind of steps!

Posted by: id scanner | Jul 22, 2010 10:11:01 AM

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