Practice Tips for Drafting Earn-Outs

Covenant of Good Faith and Fair Dealing and Its Application in Earn-Out Provisions

20150603Earn-outs are a common provision in merger agreements, allowing the buyer to defer paying a portion of the purchase price until the seller has “earned” it, meaning that seller has achieved some financial target or other agreed upon condition.  In the recent case of Lazard Technology Partners, LLC, v. Qinetiq North America Operations LLC, April 23, 2015, Strine, L., 2015 WL 1880153, the Delaware Supreme Court made an important ruling regarding the covenant of good faith and fair dealing and its application in earn-out provisions, from which attorneys can learn good practice tips for earn-outs.

Background

Qinetic North America Operations (“Buyer”) acquired Cyveillance, Inc. (“Seller”) for $40M. The merger agreement included an earn out provision that said that if certain revenue targets were achieved, Seller may receive up to an additional $40M. The key language from the earn out provision reads as follows:  Buyer was prohibited from “taking any action to divert or defer revenue with the intent of reducing or limiting the Earn Out Payment” (“Earn Out Provision”).

Not surprisingly, revenue targets weren’t reached and earn out payments weren’t made. Lazard as the seller’s representative brought suit against the Buyer alleging (1) breach of the Earn Out Provision and (2) violation of the covenant of good faith and fair dealing by Buyer for failing to take certain actions that Seller believed would have resulted in the revenue target being reached.

Ruling

Delaware Supreme Court affirmed the Court of Chancery’s decision in favor of Buyer, finding that (1) there was no proof that Buyer intended to avoid the earn out and (2) the implied covenant of good faith and fair dealing couldn’t be relied on because “there was no gap to be filled”, i.e. the Earn Out Provision was clear on the obligations of Buyer.  Both courts took a 4 corners approach to the merger agreement and found that there was no violation.

Practice Tips for Drafting Earn-Outs

The Lazard Qinetic case yields good practice tips for drafting earn-outs that attorneys representing either buyer or seller can apply.

In representing the buyer attorneys should either (a) disclaim any implied duty of good faith and fair dealing or (b) make very clear in the earn out provision of the merger agreement what the express post-closing obligation of Buyer is, including the standard to be used. In this case, the Earn Out Provision was clear that it was an intent based standard.  What helped in this case was that there was a track record during negotiation that Buyer rejected all attempts by Seller to include more stringent post closing covenant (ex: act in good faith to maintain level of business, preserve customer relationships, etc.). Seller agreed to not include these provisions so the court wasn’t going to second guess the final merger agreement.

In representing the seller attorneys should (a) seek an express good faith obligation to maximize the earn out and (b) be weary of using an intent standard in a post closing affirmative covenant.

In general, I think another good practice tip is to not assume that the implied covenant of good faith and fair dealing will help to expand a party’s obligations in a dispute involving earn-outs. Attorneys should draft the merger agreement to very clearly lay out each party’s obligations.

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