An earn-out is a mechanism used in private M&A transactions to help buyers and sellers bridge valuation gaps over the business being sold. When a deal uses an earn-out, payment of at least part of the purchase price is postponed until satisfaction of a performance metric some time after the closing.

Because of the inherent risk involved in earn-outs, several underlying issues can result in challenging negotiations between buyers and sellers. Among them is a negotiation over whether the buyer should agree to a covenant that, to some extent, will govern its operation of the business after the closing. From the seller's point of view, the buyer should agree to operate the business consistently with how the seller operated it before the closing, maintain separate records for the business and take efforts to achieve the payment milestones, among other covenants. (For further discussion of the covenant issue, see Practice Note, Earn-outs: Structuring an Earn-out: Post-closing Operation of Target Company.)

Recent decisions from the Delaware judiciary have highlighted the need for parties agreeing to earn-outs in acquisition agreements with Delaware governing law to consider including post-closing operating covenants. In each decision, the court rejected arguments by the seller that, in spite of an absence of explicit covenants, the implied covenant of good faith and fair dealing obligated the buyer to operate the business in such a way as to achieve the payment milestones.

In Winshall v. Viacom International Inc., the Delaware Supreme Court heard an appeal of the Delaware Court of Chancery's decision that, among other rulings, dismissed the shareholders' representative's complaint over payment of an earn-out (76 A.3d 808 (Del. (2013)). The representative of the selling shareholders, Walter Winshall, claimed that Viacom, the buyer of Harmonix Music Systems, Inc. (the developer of the "Guitar Hero" and "Rock Band" video games), had deliberately failed to renegotiate certain distribution fees, which reduced its earn-out payment to the selling shareholders. The acquisition agreement, however, did not contain any covenant that would obligate Viacom to renegotiate lower fees. The plaintiff therefore relied on the implied covenant of good faith and fair dealing to argue that Viacom was implicitly obligated under the agreement to avoid manipulating the target company's cost structure to lower its earn-out payment.

The Delaware Supreme Court upheld the Court of Chancery's decision to dismiss this claim. In so doing, the Supreme Court quoted several passages from the Chancery Court's decision, including the underlying principle that "the implied covenant is not a license to rewrite contractual language just because the plaintiff failed to negotiate for protections that, in hindsight, would have made the contract a better deal" (55 A.3d 629, 637 (Del. Ch. (2011)). Rather, the implied covenant's utility in these situations is to impose an obligation to act in good faith on a party who has discretion under an agreement to take certain actions.

The Delaware Court of Chancery covered this issue again in American Capital Acquisition Partners, LLC v. LPL Holdings, Inc., (Del. Ch. Feb. 3, 2014). In that case, the stock purchase agreement in dispute contained provisions for an earn-out payment on satisfaction of certain "gross margin" thresholds. The agreement, however, did not include any provision requiring the buyer to make, or to use any efforts to make, any technical adaptations necessary to allow the target business to eventually meet those thresholds.

The plaintiff seller argued that the very existence of contingent-price provisions obligated the buyer to make those adaptations under the implied covenant of good faith and fair dealing. The defendant buyer responded that the implied covenant serves a gap-filling function that is only called on when an issue arises post-signing that was not anticipated when the contract was negotiated and signed. If, however, the issue was known and the parties chose not to draft for it, the implied covenant cannot be used to create new obligations.

The court agreed with the buyer's interpretation of the implied covenant. The technical adaptations that the seller wanted the buyer to make were understood to be necessary before signing, yet the parties did not draft any obligations for those adaptations. The implied covenant's gap-filling function could not make up for that omission. At the same time, the court did find an inference that the implied covenant had been breached over certain affirmative measures that the buyer took to minimize its payments. Those measures had not been anticipated at signing and the implied covenant could be used to impose an obligation on the buyer to act in good faith to not take those actions.

Some jurisdictions are more open to the idea that earn-out provisions imply post-closing obligations on the buyer than Delaware. For example, in Sonoran Scanners, Inc. v. PerkinElmer, Inc., the US Court of Appeals for the First Circuit held that, under Massachusetts law, an earn-out contained an implied contractual term requiring the buyer to use reasonable efforts to develop and promote the acquired business 585 F.3d 535 (1st Cir. 2009)). (For more on this decision, see Legal Update, First Circuit Holds Earn-out May Imply Duty of Reasonable Efforts For Buyer.) Counsel therefore must be familiar with the chosen governing law of the acquisition agreement when advising on the implication of omitting operating covenants from earn-out provisions.

For the sake of awareness of market practice on this issue, Practical Law surveyed the most recent 50 private acquisition agreements overall and the most recent 50 private acquisition agreements with Delaware governing law containing earn-outs, all as summarized in the What's Market private acquisitions database. The database includes all publicly filed acquisition agreements for deals with a signing value of at least $25 million.

The most recent 50 private M&A deals containing an earn-out are dated between December 28, 2012, and February 3, 2014. Of these, 28 agreements provided for Delaware governing law and 12 provided for New York governing law. Each agreement has its own way of wording the parties' obligations, but in broad terms, the agreements can be categorized as follows, from most buyer-friendly to most seller-friendly:

One agreement also referenced an exhibit, which was undisclosed, that contains the earn-out covenants.

For Delaware-law acquisition agreements, the last 50 deals with an earn-out date back to May 14, 2012. The survey results are as follows:

Three agreements also referenced an exhibit, which was undisclosed, that contains the earn-out covenants.

Though some statistical differences can be found at the margins, it would not appear that there is a significant distinction in market practice between Delaware and elsewhere. Most agreements do not leave the issue of post-closing covenants entirely silent, but a substantial portion do. These are the situations where it is most incumbent on counsel to advise their clients of the relevant judiciary's view of implied contractual obligations in deals with earn-outs.