Over the last several years, Delaware courts — especially the Court of Chancery — have seen an increase in litigation involving earnout provisions in merger agreements. Each of these cases presents unique facts reflecting the individual circumstances of the parties, but the focus of disputes involving earnout provisions usually remains the same. Specifically, “[i]n what is an all-too-predictable pattern in these transactions, the parties later [become] embroiled in a seeming intractable dispute regarding whether the earn-out targets were satisfied.”1 The increase in earnout disputes has allowed the Delaware courts to develop an expertise in this area, resulting in significant precedent interpreting what standards parties must meet to comply with these provisions.
The main issue in these cases is whether the buyer complied with its responsibilities under a “best efforts” provision, which provides the buyer with discretion to run the surviving entity so long as the buyer’s efforts are, for example, “reasonable,” “commercially reasonable” or in “good faith.” In the broader M&A context, Delaware courts have determined that these variations of best efforts provisions have roughly the same meaning — i.e., “to take reasonable steps” to comply with the provision — and Delaware courts have used the same approach to interpret best efforts provisions related to earnouts.2 With this in mind, the parties in an earnout transaction need to thoughtfully consider the language of best efforts provisions so the expectations of both the seller and buyer are met.
Background
Under an earnout provision, the seller pays an upfront amount and promises to pay additional consideration if the surviving entity exceeds targets set forth in the merger agreement. When drafting these agreements, the parties have different goals in mind — the buyer wants to maintain its discretion to run the surviving entity, but the seller wants to ensure that the buyer’s performance will meet or exceed the earnout targets.3 The parties often include best efforts and integration provisions that require the surviving entity to take certain steps to meet the required goals.4 In most instances, the best efforts provision will be tailored to the buyer’s business, as well as its own internal standards and industry standards. Depending on the industry, these business practices and standards will vary. There are also provisions defining key terms that are used to mark progress towards achieving the earnout. The buyer or surviving entity’s compliance with these terms and standards, and how the parties interpret and measure success, often lead to disputes resulting in litigation.
Recent Examples of Earnout Disputes
STX Business Solutions, LLC v. Financial-Information-Technologies, LLC
In STX, the merger agreement contained a buyer-friendly best efforts provision, which gave the buyer broad discretion to run the business “so long [as] the Buyer did not take action in bad faith or with the specific intention of causing a reduction in the Earnout.”5 The surviving entity, using its business judgment, decided not to pursue a transaction that could have met an earnout target because the transaction could have “cause[d] complications” for its business.6 The seller, in opposition to the defendants’ motion to dismiss, posited that the defendants’ inaction was done in bad faith to avoid hitting the earnout target.7 But the court rejected this argument stating that “[a] party does not act in bad faith by relying on contract provisions for which that party bargained where doing so simply limits advantages to another party.”8 For these reasons, the Court of Chancery granted the defendants’ motion to dismiss.9
Fortis Advisors LLC v. Johnson & Johnson
In Fortis Advisors LLC v. Johnson & Johnson (Johnson & Johnson), the parties entered into a merger agreement that allowed the surviving entity to use its “commercially reasonable efforts” and “usual practice” for obtaining regulatory approvals for two medical devices — i.e., iPlatform and Monarch.10 These regulatory approvals also served as the earnout targets.11 Ultimately, the defendants missed several earnout targets, and the plaintiff sued alleging that the defendants failed to use its commercially reasonable efforts.12 After trial, the court found that Johnson & Johnson (J&J) deviated from its usual practice by impairing iPlatform’s development.13 Specifically, the Court of Chancery stated that “[i]t is obvious from the record that J&J’s efforts toward the iPlatform regulatory milestones were not commercially reasonable, as defined in the Merger Agreement.”14 In relation to Monarch, the Court of Chancery concluded that J&J’s “actions, or lack thereof, were flawed and may [have] prompted unintended delays, but they [were] not commercially unreasonable[.]”15 In its post-trial opinion, the court held that the defendants breached the merger agreement.16
Himawan v. Cephalon, Inc.
In Himawan, the merger agreement provided that the surviving entity had “complete discretion” to run the business, except that the surviving entity had to develop a product using the “commercially reasonable efforts” of “a company with substantially the same resources and expertise[.]”17 Later, the surviving entity decided to stop developing the product, which was the basis for the earnout targets, after the surviving entity determined that further development was not feasible.18 The surviving entity was then purchased by another buyer, which assumed the surviving entity’s earnout obligations, and the new buyer also determined that developing the product was not feasible.19 The Court of Chancery, in a post-trial opinion, found that the commercially reasonable efforts provision applied an objective standard based on a hypothetical company of similar resources and expertise.20 Employing this standard, the court determined that the defendants did not breach the merger agreement because the defendants’ actions were consistent with “pharmaceutical companies that faced similar circumstances[.]”21
Fortis Advisors, LLC v. Dematic Corp.
In Dematic, the parties used earnout targets based on the sale of “Company Products,” which was defined “very generally” in a schedule containing one- or two-word terms.22 The parties disputed whether “Company Products” included the seller’s final versions of software, or whether “Company Products” included the seller’s pieces of code that were integrated into the buyer’s software.23 Then-Judge Abigail LeGrow wrote a post-trial opinion — later affirmed by the Delaware Supreme Court — explaining that the term “Company Products” was ambiguous. After considering the extrinsic evidence and the contract structure, the court concluded that “Company Products” was intended to include the pieces of code for purposes of calculating the earnout.24 In particular, the court stated that “[t]he extrinsic evidence offered at trial supports Fortis’s interpretation of Company Products as including [pieces of] code integrated into other products[.]”25
Key Points
- Vice Chancellor Lori Will, in Johnson & Johnson, emphasized the importance of “carefully drafting language that delineates the efforts expected of the buyer relative to the achievement of the milestones.”26 Parties need to be aware of the different types of best efforts formulations because these provisions can have a substantial impact on a case’s outcome.
- That said, Delaware courts will seek to enforce the plain language of the merger agreement to determine what level of discretion is afforded to the surviving entity, and how this discretion is cabined or limited by the best efforts provisions.
- Parties have the option of drafting a best efforts provision that states the buyer should use “reasonable efforts,” “commercially reasonable efforts” or “good faith efforts.” “But there is no agreement in case law over whether they create different standards. Delaware courts have viewed variations of efforts clauses — particularly those using the term ‘reasonable’ — as largely interchangeable.”27 Hence, parties might consider other ways to expand or limit the buyer’s discretion to run the surviving entity.
- Delaware courts may find a breach when the buyer causes the surviving entity to take actions inconsistent with the buyer’s commercially reasonable efforts as defined in the merger agreement.
- When interpreting ambiguous contract terms in an earnout provision, a Delaware court will consider extrinsic evidence and the structure of the agreement to determine the intent of the parties. During drafting, the parties should consider defining terms clearly within the earnout provision to avoid a “glaring lack of clarity” when interpreting the provision.28 Additionally, clearly defining the term “company products” can avoid issues when calculating whether a financial-based earnout target has been met.
- Interestingly, several of these decisions are post-trial opinions interpreting the agreement or making factual findings on a party’s bad faith or best efforts.29 Parties, along with counsel, should try to proactively address the terms and conditions of earnout provisions before executing the merger agreement.
1 Fortis Advisors, LLC v. Dematic Corp., 2022 WL 18359410, at *1 (Del. Super. Dec. 29, 2022) (LeGrow, J.), aff’d, 319 A.3d 305 (Del. 2024) (TABLE).
2 Fortis Advisors LLC v. Johnson & Johnson, 2024 WL 4048060, at *22 (Del. Ch. Sept. 4, 2024).
3 Id.
4 Id.
5 STX Bus. Sols., LLC v. Fin.-Info.-Techs., LLC, 2024 WL 4645104, at *3 (Del. Ch. Oct. 31, 2024).
6 Id. at *4.
7 Id.
8 Id. (quoting Nemec v. Shrader, 991 A.2d 1120, 1128 (Del. 2010)).
9 Id.
10 Johnson & Johnson, 2024 WL 4048060, at *14.
11 Id. at *12–14.
12 Id. at *17–19.
13 Id. at *24–34.
14 Id. at *26.
15 Id. at *33.
16 Id. at *56.
17 Himawan v. Cephalon, Inc., 2024 WL 1885560, at *3–4 (Del. Ch. Apr. 30, 2024); see also S’holder Representative Servs. LLC v. Alexion Pharms., Inc., 2024 WL 4052343, at *36–47 (Del. Ch. Sept. 5, 2024) (analyzing a similarly worded best efforts provision).
18 Himawan, 2024 WL 1885560, at *4–7.
19 Id.
20 Id. at *12–15.
21 Id. at *13.
22 Dematic Corp., 2022 WL 18359410, at *3.
23 Id. at *12–13.
24 Id. at *17–21; see also S’holder Representative Servs. LLC v. HPI Hldgs., LLC, 2023 WL 3092895, at *4–6 (Del. Ch. Apr. 26, 2023) (interpreting an earnout provision).
25 Dematic Corp., 2022 WL 18359410, at *19.
26 Johnson & Johnson, 2024 WL 4048060, at *23.
27 Id. at *22.
28 Dematic Corp., 2022 WL 18359410, at *18.
29 Edward P. Welch et al., Mergers & Acquisitions Deal Litigation Under Delaware Corporation Law § 6.01[B] (1st ed. Supp. 2024).
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