Earn-Outs Back in the Delaware Spotlight
Divergent views of valuation is almost always the biggest hurdle to overcome when matching potential buyers and sellers in venture-backed M&A exits. Buyers obviously want to take as little risk as possible, whereas sellers are highly motivated to seek the maximum sales price. Earn-outs are often a way to bridge those gaps.
In theory, earn-outs are great. The parties come up with a "pay for performance" formula that eliminates a significant portion of the overpayment risk for buyers while still making sure that a seller receives maximum value, assuming that the acquired company performs as good or better than advertised. In reality, earn-outs are fraught with risk due to the likelihood of post-closing disputes over the calculation of the earn-out payment, whether the buyer lived up to expectation in attempting to maximize the performance of the acquired business for purposes of triggering the full earn-out payment, and so on.
A recent Delaware Court of Chancery decision highlights some of the pitfalls that executives and attorneys should try to avoid when using earn-outs. There are three principal takeaways from the case:
- Buyers should insist on express non-reliance provisions in all acquisition agreements that contain earn-outs or other post-closing obligations to ensure that any claim of detrimental reliance is decided within the four corners of the agreement.
- A Delaware court is unlikely to read into an agreement unwritten provisions or protections when a sophisticated party failed to failed to negotiate such provisions or protections into the agreement itself.
- Earn-outs, while a great way to bridge the valuation gap between buyers and sellers, should be handled with great care during drafting.
