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Earnouts always seem like such a good idea at the time.  This K&E memo is a reminder of just what a post-closing mess they frequently turn out to be.  The memo looks at two recent Delaware cases – Chancellor Bouchard’s decision in Shareholder Representative Services v. Gilead Sciences (which I blogged about a few weeks ago) & Vice Chancellor Laster’s decision in Shareholder Representative Services v. Valeant.  The cases illustrate that when it comes to earnouts, there are all kinds of ways to get into trouble.

The trouble with the Gilead case was the use of an ambiguous term to define a contractual payment milestone. That ambiguity compelled the Chancellor to look at extrinsic evidence in order to interpret the term’s meaning.  Here’s the key takeaway from that decision:

The lesson for buyers and sellers is to leave no room for ambiguity as to what type of approval satisfies a milestone. Both industry and colloquial terms used in defining a milestone (on the assumption of “everyone knows what we mean here”) are susceptible to misinterpretation when litigated years later.

Parties may want to use clear examples in the contract itself (e.g., under a “for the sake of clarity…” introduction) of what will, and what will not, satisfy the milestone. Also, in case a court determines that a contract is ambiguous, parties should ensure that documents outside the agreement, like summaries for boards, term sheets, pre-contract letters of intent, etc., don’t shorthand the description of the milestones and are instead very clear on the intended hurdle.

That makes sense.  But will this approach keep you out of trouble with earnouts?  Based on the court’s approach in Valeant, maybe not.  That case involved explicit provisions laying out what the buyer’s post-closing efforts obligations were when it came to causing the earnout to be triggered – but that still wasn’t enough to keep the buyer out of hot water:

The agreement did have fairly developed and explicit definitions of the required post-closing diligent efforts from the buyer, delineating both general standards for the required efforts plus four specific requirements on matters like minimum spending and staffing. The sellers alleged that the buyer’s high pricing of the acquired product, while not contrary to any of the general standards or specific requirements, violated the implied covenant of good faith by being unreasonable and therefore causing sales to be lower than anticipated.  The court acknowledged that the contractual provisions were detailed and even covered “commercialization”  of the product.

In spite of that, the court held that it could not dismiss an argument that pricing was separate from commercialization (stating that that term “maps imperfectly onto the idea of pricing”), therefore leaving room for an implied covenant claim arising out of the buyer’s pricing decisions. The court made a similar finding about the buyer’s decision to sell the product through a particular pharmacy channel.

The memo recommends that the best way to minimize the risk of controversy is to be as clear and specific as possible in drafting payment milestones and efforts obligations.  To reduce the risk of judicial gap filling through an implied covenant of good faith, it also suggests that the parties “may wish to err on the side of over-inclusiveness and repetition” – and also include language indicating that the explicit terms of the contract are intended to override any such implied covenant.

–John Jenkins