Top Six Legal Issues In Earnout Lawsuits

An "earnout" is an agreement between the buyer and seller of a business where a seller can obtain an additional payment if the business later achieves a financial performance target. The earnout is typically memorized in a purchase agreement and is sometimes expressed as a contingent purchase price, meaning that the buyer must pay an additional purchase payment contingent on future performance of the business. Earnouts can be an effective way to bridge the gap between a buyer and seller at the deal stage, but these provisions frequently spawn lawsuits when the earnout payment is not made. As one court commented, an earnout reflects "a disagreement over the value of the business that is bridged when the seller trades the certainty of less cash at closing for the prospect of more cash over time . . . But since value is debatable and the causes of underperformance equally so, an earnout often converts today's disagreement over price into tomorrow's litigation over the outcome." Aveta, Inc. v. Bengoa, 984 A 2d 126, 132 (Del. Ch. 2009). A review of the caselaw reveals recurring legal issues, and suggests that there is uncertainty in these cases, and no easy path to resolution.

Alternative dispute resolution versus court: Where should the parties litigate the issue? The first recurring issue in earnout litigation is choice of forum. Most earnout agreements have an alternative dispute resolution ("ADR") provision (such as a referral of disputes to an arbitrator or independent accountant). Parties nevertheless often litigate whether particular issues must be resolved in court. In many cases, parties are surprised to find that both courts and arbitrators weigh in even when the contract requires mandatory ADR for earnout disputes.

In a case where a disappointed seller who does not receive an earnout sues for claims arguably not covered by the ADR language, the parties can become embroiled in litigation to determine jurisdiction over the claim. For example, the plaintiff may claim that the dispute does not involve the earnout calculation itself, but instead whether the buyer acted in bad faith to artificially burden the acquired company (for example by loading the company with affiliate expenses in order to depress profitability, or delaying consummation of lucrative transactions until just after the expiration of the earnout period). As another example, a disappointed seller could allege the violation of duties outside the contract; for example, a fraudulent inducement claim based on representations that the buyer had the skill, expertise, and commitment to competently operate the acquired business - representations that were allegedly false when made and which prevented the business from reaching the earnout target.

Plaintiffs who want to avoid ADR can argue that the dispute does not implicate the power the contract gives to the arbitrator or accountant, or is beyond the expertise of the accountant and requires court evaluation. For example, one court permitted the parties to litigate, notwithstanding a mandatory ADR clause requiring referral to an independent accountant:

I]t makes no sense to assume that accountants would be entrusted with evaluating disputes about the operation of the business in question. Yes, operational misconduct may well affect the level of earnings and therefore the schedules, but the misconduct itself would not...