Implied duties

In the wake of several court decisions in the US, private equity professionals looking to use earnouts to bridge pricing gaps between buyers and sellers should consider having an explicit disclaimer of implied duties, especially when doing transactions in certain states.

Earnouts have become particularly useful in the current environment, in which many sellers do not think that recent performance is indicative of the true value of their company, while buyers prefer to stick with current valuations. Earnout payments – by which the buyer agrees to pay a certain amount at closing, followed by a supplemental payment later if certain performance targets are met – are one way for both sides to meet in the middle.

However, this may become more difficult following an October decision in which the US Court of Appeals for the First Circuit found that an acquiring company had an “implied” obligation to exert reasonable efforts to develop and promote the products of a purchased company, in order to maximise earnout payments to a seller.

The court was ruling on a case that involved a 2001 transaction in which PerkinElmer acquired the computer-to-plate (CTP) business of Sonoran Scanners. Pursuant to an asset purchasing agreement, PerkinElmer paid Sonoran $3.5 million at closing, while Sonoran had the ability to earn an additional $3.5 million in earnout payments if certain sales targets were met.

However, since PerkinElmer was only able to sell one unit of its CTP product following the acquisition, no earnout payments were made to Sonoran. After Sonoran sued PerkinElmer for not exerting reasonable efforts in developing and promoting its products, the First Court relied on a 1942 Massachusetts Supreme Court case in siding with Sonoran, saying that the duty to use “reasonable efforts” should be implied.

Among the factors the court cited were the substantial size of the potential earnout payments relative to the closing payment, the lack of explicit language in the asset purchase agreement disclaiming an obligation to use reasonable efforts, and the lack of explicit language conferring on PerkinElmer exclusive discretion in the operation of the business.

The ruling has called into question exactly how much discretion a purchaser has to operate a purchased business when the seller is entitled to an earnout payment. It is also the latest in a trend of similar rulings over the last few years in New Jersey, New York, Delaware and Pennsylvania.

However, while it is unlikely that such decisions will heavily deter the use of earnouts in the future, private equity professionals should consider a few measures to guard against getting caught up in a similar court ruling.

A key consideration highlighted by Massachusetts law is that purchasers may have to bargain to include a disclaimer expressly stating that the buyer has the right to run the business as they wish, even if it means running it into the ground. “The way the law works you really need a seller to say it is okay if you mess up and the business doesn’t do well,” said David Denious, partner in the corporate and securities practice at Dechert. “That can be a difficult decision, but you need that to be pretty much explicit. Of course sellers don’t want to agree to that, so what you usually get is something that’s a little more fuzzy.”

Either way, he adds, any type of disclaimer is better than nothing. “It signals to a judge that you had a discussion with the seller about the scope of these duties post-closing, and here is what you and the seller agreed to. And the fact that the seller didn’t do better, that is just the way contracts work,” Denious said.

A low upfront payment/high earnout payment ratio should also be avoided if possible, such as paying $1 million at closing and then earning $30 million if the business performs well. A judge may assume the seller was somehow ripped off and side with him, so a more significant upfront payment, without undercutting the purpose of the earnout, should be considered.

Much of this will depend on the jurisdiction though, as some states have more seller-friendly laws than others. Denious says that New Jersey is more favourable to buyers and New York, Pennsylvania, California and Massachusetts are less favourable, with Delaware in the middle.