Early stage companies with valuable intellectual property often receive solicited or unsolicited opportunities to sell their business, which a buyer may view as a means of acquiring intellectual property. Differences as to enterprise valuation may be bridged through an "earnout" mechanism whereby the buyer pays an initial amount at closing and, if certain milestones are met post-closing, an additional amount.
Sellers resist earnouts because, following closing, strategic issues that relate directly to the profitability of the business, which in turn directly affect whether an earnout will be paid to the seller, are to be decided by the buyer. As a result, sellers may seek to impose approval rights relating to the buyer's conduct of the business post-closing. Buyers will often resist this on the basis of "we bought it, we own it, we run it."
The end result is often the inclusion of language in the acquisition documentation similar to the language at issue in Lazard Technology Partners, LLC v. Qinetiq North America Operations LLC, where the buyer was prohibited from "tak[ing] any action to divert or defer [revenue] with the intent of reducing or limiting the Earn-out Payment." There, when an earnout payment was not forthcoming, the seller sued arguing the buyer had breached its contractual obligations and had violated the implied covenant of good faith and fair dealing which is considered to underlie every commercial transaction.
The Delaware Court of Chancery held for the buyer, finding that the seller had not proven that the buyer had intended to limit the earnout, and that, notwithstanding that the buyer's actions may have impacted the likelihood of an earnout, the court could not conclude that the buyer intended to reduce or limit the earnout. The court also found the implied covenant of good faith and fair dealing was not applicable because there was no "gap to be filled" in the heavily negotiated acquisition agreement, which spoke for itself as to the buyer's obligations.
The Delaware Supreme Court affirmed the Court of Chancery, suggesting that the implied covenant of good faith and fair dealing could exist side by side with a contractual covenant, but ultimately holding "the implied covenant did not prohibit the buyer's conduct unless the buyer acted with the intent to deprive the seller of an earn-out payment."
Sellers negotiating earnout arrangements should therefore not rely upon the implied covenant of good faith and fair dealing when the definitive agreement establishes a standard to be applied to the buyer's post-closing actions. On the other hand, Buyers should disclaim any implied duty of good faith and fair dealing so as to avoid application of an objective standard that may expand the contractual standard of behavior negotiated by the parties in the acquisition agreement. This will help to retain focus on the buyer's intent and will help to limit or eliminate an examination of the ultimate result of any decision by the buyer that conceivably impacts its obligation to make an earnout payment to the seller.
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