What was old is new again: earnout litigation is once again on the rise. Earnout clauses are an increasingly common feature of M&A deals (one recent study found that the use of earnouts in U.S. private M&A deals in 2022 was higher than in any year since 2017) and unsurprisingly, the rising use of earnouts has been accompanied by an increase in earnout disputes, with the number of U.S. lawsuits involving earnouts nearly doubling between Q1 of 2022 and Q1 of 2023.1
Earnouts are a useful tool in negotiating M&A agreements because they allow parties to allocate some of the risk regarding the future performance of the target company to the seller. The rising popularity of earnouts may stem from recent increases to the cost of capital and uncertainty regarding the current financial environment, prompting parties to a transaction to look for ways to defer payment until a later event. Often, the seller continues to have a robust view of their business, while macro-economic or capital markets trends—or specific concerns about trends in the target’s business—cause the purchaser to assign a lower value to the company. Earnout clauses are used as a solution to bridge the gap in value created by these differences in view.
While there are certainly benefits to earnout provisions, without careful drafting they may lay the groundwork for future litigation. We outline several important considerations below, based on a review of recent Delaware cases, that may reduce the risk of an earnout dispute arising and help the parties navigate disputes when they occur.2
Clearly Define Milestones
Earnout payments are typically triggered by events or targets that occur after the closing of the transaction, often called milestones. A typical earnout provision might call for payment once the purchased product receives regulatory approval or if the company achieves a certain EBITDA target. In other scenarios, the parties may condition a future payment on developing a certain product by a target date. If milestones are not clearly defined, however, the parties may end up disputing whether or not a milestone was achieved.
One recent Delaware case demonstrates the risk of ambiguously-defined milestones in an earnout provision. In Fortis Advisors v. Dematic Corporation, the parties agreed that the buyer would pay the seller based on sales of the “Company Products.”3 The contract did not clearly define the term “Company Products,” nor did it cover a scenario in which the buyer integrated the products manufactured by the acquired business into its existing products. When the buyer calculated the earnout fee it owed the seller, it did not include sales of integrated products. The dispute escalated into a lawsuit that could have been avoided by a less ambiguous provision.
Contractual Language Regarding Efforts to Meet Earnout Milestones
The structure of earnout provisions may create a lopsided incentive to meet a milestone. If an earnout is tied to reaching an EBITDA target, for example, a seller will be incentivized to help the company reach that target as quickly as possible. The buyer, on the other hand, may want to focus company resources on other goals. To deal with this problem, parties may include provisions limiting a seller’s right to influence or interfere in business decisions.
Two recent cases from the Delaware Court of Chancery highlight the importance of clearly delineating control over business decisions.4 In Pacira BioSciences v. Fortis Advisors, a buyer claimed that the seller interfered with its business decisions in an effort to ensure that an earnout payment would be triggered. The earnout was due only if the buyer obtained a specific reimbursement rate from the Centers for Medicare and Medicaid for one of its medical devices. To ensure that the buyer achieved the milestone, the seller reached out to the buyer’s employees to demand action and contacted the regulator to advocate for the reimbursement rate. Although the M&A agreement gave the buyer the right to operate the business “in its sole discretion,” the court held that it imposed no limitation on the seller’s ability to contact employees or regulators.
The case Neurvana Medical v. Balt USA presents the opposite scenario: there, a buyer failed to meet an earnout milestone despite numerous offers of assistance from the seller. As a result, the seller claimed that the buyer had interfered with the seller’s right to an earnout fee. The court disagreed because the buyer had “sole discretion” over “all matters relating to” the product and while the seller was entitled to offer assistance, the buyer had no obligation to accept it.
Contractual clauses may also require the buyer to expend a certain amount of effort to meet a milestone. In Himawan v. Cephalon, for example,5 the milestone was development of an antibody and the merger agreement required the buyer to use “commercially reasonable efforts” to achieve the milestone while otherwise giving it discretion on how to do so. The efforts clause further defined “commercially reasonable efforts” as “the exercise of such efforts and commitment of such resources by a company with substantially the same resources and expertise as [the buyer], with due regard to the nature of efforts and cost required for the undertaking at stake.” In other words, the efforts clause created a standard based on the effort that similarly situated companies would employ.
When the buyer did not achieve the milestone, the seller sued for breach of contract, claiming that the buyer breached the efforts clause. Rather than dismissing at the pleading stage, the court allowed the case to proceed to discovery, explaining that the assessment of the buyer’s decisions required a factual inquiry into whether they violated the efforts clause. Clear drafting of the exact efforts required, as well as provisions defining the scope of the parties’ discretion in achieving earnout milestones, may have avoided the dispute.
Explicit contract terms may not be the only factor courts use when interpreting the rights and obligations of the parties vis-à-vis an earnout provision. The covenant of good faith and fair dealing, implied in every contract, precludes a party from engaging in conduct that will deprive the other party of the benefits of the bargain. A seller which is unable to receive an earnout payment because the buyer did not reach the earnout milestone might claim that the buyer breached the implied covenant by preventing achievement of the milestone.
For example, in Neurvana, the seller argued that the buyer breached the implied covenant through its decision to pursue an unsuccessful protocol for approval of the medical device that was the subject of the milestone. The court, however, found for the buyer, emphasizing that the implied covenant is a gap-filling mechanism and applies only when the contract “is truly silent” on the matter at hand. It cannot be used to rewrite the contract and “should not be applied to give plaintiffs contractual protections that they failed to secure for themselves at the bargaining table.” In other words, if a contract expressly addresses the efforts required to reach a milestone, or if it grants the buyer discretion over the conduct affecting milestones, it will be difficult, if not impossible, for a seller to argue that buyer breached the implied covenant by acting in accordance with express provisions of the contract.
When drafting, both parties should pay close attention to the issue of control and should clearly define both the seller’s and the buyer’s post-closing conduct that may influence achievement of milestones.
Choice of Forum for Earnout Disputes
Parties can typically choose a forum for any dispute arising from the contract, including over the meaning of an earnout clause or any condition precedent to earnout payment. Many agreements with an earnout clause include an alternative dispute resolution provision referring disputes either to an arbitrator or an expert, and in some cases, a price adjustment provision includes its own dispute resolution mechanism separate from the rest of the contract. It is important to remember, however, that a clause requiring submission of an earnout dispute to an arbitrator or an expert does not necessarily foreclose litigation. If the parties disagree over the scope of the ADR clause, they may need to litigate the meaning of the choice of forum clause in a court. In Fortis Advisors, for example, the contract required that a neutral accounting expert determine the size of the payout. The defendant tried to avoid litigation by referring the entire dispute to the neutral expert, but the court determined that, because the dispute was one of contract interpretation, it involved legal questions that must be resolved by a court.
Creating a Record
Parties planning to use an earnout provision should practice good recordkeeping from the start of negotiations. A clear record of how the parties understood the terms of the earnout at the time of drafting may be crucial in a dispute, especially if the court concludes that a contractual term is ambiguous.
The Dematic case provides an example: there, the court held that the term “Company Products” was ambiguous and allowed the parties to introduce extrinsic evidence regarding how the products were made, the recommendations of the diligence team at the time of the transaction, and communications between the parties that reflected their understanding of the product at the time of signing.
In another recent case, Schneider Natl. Carriers, Inc. v. Kuntz, the agreement imposed strict constraints on the buyer’s management of the company in an effort to ensure that the company met its earnout EBITDA targets.6 One constraint required the buyer to purchase “60 tractors” per year, and if it did not, the seller would receive the full earnout payment regardless of whether the EBITDA targets were met. The court determined that the requirement was ambiguous because the parties disputed whether the buyer had to simply purchase 60 tractors, or whether it had to grow its fleet of vehicles by 60 tractors per year. The court admitted extrinsic evidence, most crucially the parties’ negotiating history, and after a four-day trial and consideration of almost 300 exhibits, agreed with the seller’s interpretation and required the buyer to pay a $40 million earnout fee.
In addition to keeping records of negotiations, it is important to keep records of efforts taken in connection with the earnout milestones. For example, if the buyer is required to use “best efforts” to purchase 60 tractors per year, it is helpful to create a record of what efforts have actually been undertaken.
- While earnout provisions may seem to be an attractive solution to the problem of pricing a transaction in an uncertain economy, parties should carefully weigh arguments for and against including earnout provisions. Often, disputes resulting from earnout provisions mean that the parties’ negotiations over price are effectively only postponed until after closing.
- Given the complexity of a typical earnout provision, parties frequently disagree on the interpretation of earnout clauses, which can lead to costly and lengthy litigation. The parties can reduce the risk of post-transaction disputes through careful drafting.
- The parties should be clear about whether the seller can be involved with the business post-closing in ways that impact the milestones, whether the buyer is obligated to take certain objectively defined steps in connection with the milestones, or whether discretion is left to the buyer to run the business as it sees fit.
- The parties should remember that courts interpret earnout provisions not as standalone clauses, but as part of the contract as a whole. Keeping a record of business decisions and negotiation of the earnout provision, as well as efforts taken to achieve the milestones, is important for proving your case in any future litigation.
 Earnouts are also used in public company deals—especially in the life sciences industry—where they are usually implemented through issuance of a contingent value right (“CVR”).
 Earnouts (and earnout disputes) are also common in other, non-U.S. jurisdictions, although the law regarding earnouts and related issues varies by jurisdiction.
 Fortis Advisors, LLC v. Dematic Corp., 2022 WL 18359410 (Del. Super. Dec. 29, 2022).
 Pacira BioSciences, Inc. v. Fortis Advisors LLC, 2021 WL 4949179 (Del. Ch. Oct. 25, 2021); Neurvana Med., LLC v. Balt USA, LLC, 2020 WL 949917 (Del. Ch. Feb. 27, 2020).
 Himawan v. Cephalon, Inc., No. CV 2018-0075-SG, 2018 WL 6822708 (Del. Ch. Dec. 28, 2018).
 Schneider Natl. Carriers, Inc. v. Kuntz, No. CV N21C-10-157-PAF, 2022 WL 1222738 (Del. Super. Apr. 25, 2022).