DealLawyers.com Blog

Earnouts are perhaps the most contentious of deal terms, and over the years, disputes about earnout provisions have provided us with a rich source of blog topics. Despite all the problems with them, earnouts continue to be a popular tool for bridging valuation gaps. If you’re thinking about incorporating an earnout into a deal you’re working on, you may want to check out this recent Cooley memo, which offers up four drafting tips to avoid earnout disputes.  This excerpt addresses the need to explicitly define the terms used to measure “efforts” obligations:

Drafters should clarify whether the buyer has an obligation to operate the acquired business in such a way as to maximize the earnout opportunity for the benefit of the seller. However, inclusion of so-called best efforts or commercially reasonable efforts clause, without further detail or definition, can lead to uncertainty.

In the Delaware Chancery’s 2022 decision in Menn v. ConMed Corp., for example, the contract between the buyer and seller included a “commercial best efforts” provision. While some “commercial best efforts” clauses contain what is called a contractual yardstick — a method to measure the efforts — the contract in Menn lacked any express standard by which to gauge the buyer’s efforts.

The court turned to other sources of interpretation for best efforts and found that, in that context, “commercial best efforts” required “a party to do essentially everything in its power to fulfill its obligation.”

The Menn case should serve as a warning to buyers to build guardrails into earnout provisions around how they will be expected to manage the business post-closing, such as whether they must retain certain employees; continue past practices, including discounts and training; and fund future improvements or development.

Other drafting tips include using clear and unambiguous terms, setting strict timelines for dispute resolution, and clearly defining what disputes will go to an expert.

– John Jenkins