Delaware Chancery Court provides helpful drafting tips in Earnout case

After taking the summer off from blogging, its time to write again. I thought I would go back to one of my favorite topics to discuss – one often ripe for dispute – earnouts. An interesting decision by the Delaware Chancery Court last month raises some drafting issues.

The case involves a dispute over an EBITA-based earnout between sellers of a life-sciences startup and buyer, AmerisourceBergen Corporation. The deal involved a $21 million closing payment and an earnout of $55 million based on 2003 and 2004 results. Because Sellers saw this deal as giving them access to a larger marketing platform, they obtained buyer’s agreement to exclusively promote seller’s products as part of AmerisourceBergen’s marketing pitches. The merger agreement also included language expressly requiring buyer to use “good faith” and not undertake any actions that would impede the earnout benefits to the sellers.

Notwithstanding these seller-favorable provisions and a finding by the Court in favor of liability for breaching the agreement, on this issue the Court only awarded nominal damages of 6 cents. (The Court did award $21 million on a separate claim that the earnout metric was miscalcuated, so the sellers did have something to celebrate). So, a liquidated damages clause may have been useful here to the sellers.

Another issue was cost control as related to the earnout computation. The agreement clause did not prevent sellers from controlling (reducing) its expenses during the earnout period. A buyer in this case may consider providing that any reductions in expenses (that are not buyer-approved) will get backed out of the EBITDA or other similar earnout metric. Conversely, sellers should try to control as much of the action as possible, so buyer’s increases in overall corporate spending do not dilute their earnout.

The term “average” was also in dispute. Buyer argued that average meant “weighted average,” while the contract was silent. The court did not find this argument compelling (“the most straightforward usage of the term ‘average’ is an arithmetic mean, or an average in which each term is given equal weight”). So, if you mean weighted average, you need to say so in the agreement and then spell out the rules on how the weighting is going to work.

The case also presents an example where the parties departed from GAAP in defining the Adjusted EBITA and the Court enforced their agreement, as opposed to referring back to what GAAP may require.

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