November 20, 2023
Earnouts: Delaware Courts More Often Siding with Sellers
This Fried Frank memo calls out a “new trend” in Delaware earnout decisions:
Most earnout litigation has focused on whether the buyer has breached its general efforts obligations, or any specific covenants, with respect to its running of the business during the earnout period. Historically, in most cases, the court has found in favor of the buyer—concluding that the buyer conceivably had legitimate business reasons for running the business as it did, rather than having had a bad faith intent to frustrate the earnout. However, the most recent decisions appear to indicate a possible change in the court’s direction—with the court holding in favor of the seller in six of the seven cases.
The alert also argues that the recently reported increase in earnout usage is misleading. Instead, if you take out de-SPAC transactions, the rate of earnout usage is consistent and even a bit down.
Recent reports of a dramatic increase in the use of earnouts in M&A deals (excluding deals for development stage target companies, such as in the life sciences sector) appear to be based on the inclusion in those studies of de-SAPC mergers purportedly including earnout provisions. In the current formulation of de-SPAC mergers, however, the “earnout” provisions generally do not function as actual earnouts. That is, they do not function to bridge valuation expectations between buyers and sellers by providing the target stockholders with additional consideration if, post-closing, certain financial targets or milestone events are met by the acquired company. Rather, they typically function simply as an additional compensation “sweetener” for the SPAC sponsors and insiders (usually, if the combined company’s post-closing stock price reaches a specified target).
When de-SPAC mergers are excluded from the database of deals, the use of earnouts in 2023 to date has been about consistent with their use in the most recent years since the pandemic emerged. In 2023 to date, about 37% of M&A deals (excluding development-stage company deals and de-SPAC mergers) have included an earnout. This compares to 43% of such deals in 2022, 33% in 2021, and 36% in 2020. Prior to these pandemic-affected years, the historic rate of usage of earnouts in such deals was roughly in the range of 20-30%; and, in 2019 and 2018 (the two years just before the pandemic), the rate of usage was about 20%. Thus, current usage of earnouts remains above the historic, pre-pandemic rate—reflecting continued economic, valuation and financing uncertainties—but the rate has remained roughly consistent in 2023 with the rate in the most recent years (being somewhat down from 2022 and only slightly up from 2021 and 2020).
Similarly, earnout litigation has also not significantly spiked, according to the alert. Of course, that doesn’t mean that earnouts don’t still come with a high likelihood of post-closing disputes that might be expensive and time-consuming. This Cooley blog discussing commentary from Chancellor Kathaleen St. J. McCormick and Vice Chancellor Paul Fioravanti during a panel at the October 2023 Berkeley Fall Forum on Corporate Governance reminds us that “earnout disputes tend to be more heavily litigated than other cases and tend not to settle.” Apparently, earnout litigation has taken up a considerable amount of the Chancery Court’s time since 2016.
While the recent decisions siding with sellers may put pressure on buyers to settle rather than litigate — which it sounds like the Chancery Court would welcome — the memo reminds us that prior decisions may not be very predictive of future results given the continued emphasis on the importance of the specific language and context:
At the same time, however, and importantly, because the judicial result in all cases is heavily dependent on the specific language in the parties’ acquisition or merger agreement and the specific factual context, and because earnout provisions often are not sufficiently specific, litigation relating to earnouts carries a relatively high degree of uncertainty as to the outcome.
– Meredith Ervine