Earnouts: Where the Legalese ‘Efforts Standard’ Matters
While earnouts are not a new phenomenon, they have become a more frequently used financial tool for buyers over the last few years with the rise in interest rates and more risk averse capital markets. The use of earnout provisions in M&A purchase agreements is currently at a 5-year high, increasing from a rate of 13% in 2018 to 21% in 2022, according to SRS Acquiom 2023 Deal Terms Study.
The spike in earnouts included in purchase agreements has gone hand-in-hand with increased earnout-related litigation. Often, the question is whether the buyer put forth sufficient effort to achieve the seller’s earnout payment—in other words, whether the buyer met its obligations under the efforts standard. Although sometimes considered mere legalese, the earnout efforts standard imposed on buyers and how clearly it is described in the purchase agreement not only affects buyers’ post-closing obligations and flexibility to make business decisions, but can also be a key determiner of the outcome in earnout litigation.
What is an Earnout?
Earnouts are a form of contingent purchase price, earned and paid after the closing of a transaction, based on predetermined financial or operational metrics during a set period of time. Earnouts are a useful tool parties can use to help bridge valuation gaps, align the interests of both buyers and sellers, and mitigate risk associated with uncertainty in a target’s post-closing performance by making additional purchase price dependent on the future performance of the target. While an earnout payment is often tied to overall revenue or EBITDA, earnout metrics can also relate to items that can be linked more directly to specific action or inaction by buyers, like new product launches or sales of specific products. In any case, whether the earnout amount is actually earned can be a friction point leading sellers to point their fingers at buyers’ actions as the reason the earnout was not maximized.
The Earnout Efforts Standard
While a majority of the discussion around earnouts surrounds the earnout metrics, related definitions, and the mechanics of the earnout calculation, a crucial aspect of earnouts is the efforts standard imposed on buyers in the purchase agreement. The efforts standard in earnout provisions refers to the level of effort or diligence that a buyer is required to exert to achieve the specified performance targets or milestones outlined in the earnout provisions. The choice of the efforts standard is often a negotiation point in the contract drafting process, and the specific language used can significantly impact the parties’ obligations and outcomes of potential disputes.
There are various levels of efforts standards, each implying a different degree of commitment or obligation. Some common standards include “best efforts,” “reasonable best efforts,” “commercially reasonable efforts,” and “good faith.” In some cases, sellers may also try to impose certain covenants on buyers to supplement or replace the efforts standard, including covenants to maximize the earnout or run the business in accordance with sellers’ past practices. However, covenants like these are less common and were only accepted in 1% and 23% of transactions in 2022, respectively.
Sellers generally prefer to impose a higher standard on buyers’ post-closing actions, such as best efforts or commercially reasonable efforts to achieve the earnout, to maximize the likelihood of earning the full earnout. Buyers, on the other hand, prefer standards that provide them with more flexibility and less strict obligations, like covenants not to take actions with the intent of depriving the earnout or retaining the ability to operate the business in their sole discretion. In other instances, negotiations result in more neutral efforts standards, such as operating the business in good faith.
The Efforts Standard in the Courtroom
If an earnout dispute rises to the level of litigation, efforts standards that give buyers flexibility in their decision making, such as covenants to operate the business in their sole discretion or in good faith or prohibiting buyers from taking actions with the primary intent of depleting the earnout, make it hard for sellers to show that buyers did not meet their obligations with respect to the earnout. In instances like these, sellers have tried to look past the efforts standard stated in the purchase agreement and instead rely on the broader implied covenant of good faith and fair dealing to say that buyers have breached their duties in achieving the earnout.
While Delaware does recognize the implied covenant of good faith and fair dealing—a general principle that parties to a contract are expected to perform their contractual obligations honestly, fairly, and in good faith and not deprive the other party of the benefits of their bargain—courts have been hesitant to use the implied covenant to rewrite or contradict the express terms of a contract, including with respect to earnout efforts standards. Specifically, when a purchase agreement already specifies an efforts standard and is not silent on the issue, courts will not apply the implied covenant to impose a higher or different standard on buyers.
For example, in Neurvana Medical, LLC v. Balt USA, LLC, the purchase agreement contained a buyer-friendly earnouts standard, giving the buyer the “authority with all matters relating to [the company] after the Closing” and even specified that this included regulatory and other decisions. The seller later tried to argue that the buyer breached the implied covenant by pursuing a certain failed protocol over another protocol which may have affected the earnout. The court rejected the seller’s claim, saying that the agreement was not truly silent on the issue since it gave the buyer the discretion to make all regulatory and other decisions relating to the business post-closing, showing that a general grant of authority to run the business in buyer’s own discretion is sufficient to preclude the application of the implied covenant of good faith.
Delaware courts have rejected the application of the implied covenant even when the purchase agreement imposes a more onerous, seller-friendly efforts standard. In Fortis Advisors, LLC v. Dialog Semiconductor PLC, the purchase agreement required the buyer to use commercially reasonable best efforts to achieve and pay the earnout in full. When the earnout was not achieved in full, the seller tried to assert a breach of the implied covenant of good faith as to specific actions or inactions of the buyer. However, the court rejected that the implied covenant could be used as an alternative theory to breach of contract for the earnout provisions when the agreement clearly specified an earnout standard.
Even in the instances when the purchase agreement is silent on the efforts standard and the Delaware implied covenant of good faith applies, buyers do not have a duty to maximize the earnout. Rather, in Delaware, the implied covenant only prohibits buyers from taking affirmative actions with the purpose of frustrating or depriving the earnout (although this varies by state). This distinction was clearly shown in American Capital Acquisition Partners, LLC v. LPL Holdings, Inc. where the agreement was silent as to the efforts standard. In that case, the Delaware court denied a breach of the implied covenant based on the claim that the buyer failed to make modifications to its systems that were discussed during negotiations (an affirmative action to maximize the earnout), reasoning that the seller “chose not to bargain for specific language requiring [the buyer] to make those adaptations, and they cannot now claim that the parties did not anticipate such language would be necessary.” However, the American Capital court did find a breach of the implied covenant based on the claim that the buyer purposely diverted sales from the target company to another in order to deprive the earnout.
When the efforts standard specified in the purchase agreement imposes more onerous obligations on a buyer than the implied covenant of good faith, a seller would be more likely to make a claim on the terms of the purchase agreement rather than rely on the Delaware implied covenant. In Delaware, standards that require buyers to affirmatively use efforts to achieve an earnout (such as commercially reasonable or best efforts) appear to be more seller-friendly than the implied covenant of good faith. Conversely, when a purchase agreement only requires a buyer to operate the business in good faith and does not require any actions with relation to the earnout payment, the implied covenant would have imposed stricter obligations on the buyer if it were to apply.
It is essential for parties involved in a transaction to carefully negotiate and clearly define the earnout efforts standard to avoid potential disputes in the future. If using a more vague standard such as commercially reasonable efforts, parties should consider further detailing what those efforts might encompass. Buyers in particular should be thoughtful about what standard they are willing to agree to, as it may be applied across the whole earnout term which could span several years.
Sellers should also not be quick to rely on the implied covenant of good faith as a backstop to negotiating a fair and clear efforts standard up front. When purchase agreements clearly specify the efforts standard applied to the earnout, sellers will have a hard time claiming that buyers did not meet their obligations and an even harder time invoking the implied covenant of good faith when the earnout is not fully achieved.