In this blog post, we explore the crucial role of earnout agreements in M&A transactions and why Delaware’s implied covenant of good faith and fair dealing is not sufficient protection for sellers. A recent Delaware Court of Chancery case underscores the importance of explicitly defining buyer obligations, especially when it comes to achieving earnout milestones. The post highlights the distinction between implied and express efforts provisions, illustrating how this misunderstanding can leave sellers vulnerable. This article provides valuable insights for M&A professionals, particularly those negotiating earnouts in private company deals.
M&A Stories
February 14, 2025
An M&A seller that agrees to a significant earnout must take great care in the earnout agreement to require the buyer to use good faith or commercially reasonable effort to hit the earnout milestones. Sellers often assume that Delaware’s implied covenant of good faith and fair dealing provides sufficient protection. But that is not the case.
A recent Delaware Court of Chancery case highlights how even experienced M&A lawyers may not fully appreciate the distinction between Delaware’s implied covenant of good faith and fair dealing and an express efforts provision in an earnout agreement. This misunderstanding can leave sellers vulnerable when a buyer fails to meet earnout milestones.
During negotiations, the seller’s lawyer wanted a provision requiring the buyer to use good faith efforts to meet the revenue milestones. The buyer’s lawyer argued that such language was unnecessary because Delaware law’s implied covenant of good faith and fair dealing already obligated the buyer to act in good faith to achieve the milestones. The court later noted that the seller’s lawyer apparently accepted that assertion without insisting on explicit language.
The revenue milestones were not met, and the seller received no earnout. The seller sued the buyer, a portfolio company of the private equity firm, in the Delaware Court of Chancery for breach of contract. The seller alleged that the buyer’s actions and inactions, including splitting the company’s flagship integrated safety and training product into two separate offerings, providing insufficient sales and marketing support, limiting new customer acquisition, failing to deliver competing product revenue that was part of the earnout calculation, and restricting the seller’s autonomy to run the company—prevented the milestones from being reached.
The seller argued that these actions violated Delaware’s implied covenant of good faith and fair dealing. The buyer moved to dismiss, and the court granted the motion. It ruled that the implied covenant serves only as a gap filler where the parties have not addressed an issue in their contract. Here, the negotiations had covered buyer efforts, so the implied covenant did not apply.
The court’s decision was correct, but the case underscores an important lesson for sellers. The buyer’s lawyer was wrong in claiming that the implied covenant provides the same protection as an express efforts provision. This case is not about the distinction between express and implied efforts covenants but serves as a springboard to highlight the higher burden a seller faces under the implied covenant. If the implied covenant had applied, the seller would have needed to prove that the buyer acted intentionally and in bad faith. In contrast, if the agreement had included an explicit good faith or commercially reasonable efforts provision, the seller’s claim would have survived the motion to dismiss. The seller would only have needed to show that the buyer’s actions or inactions failed to meet its contractual obligations—regardless of whether they were taken in good or bad faith.
See: Trifecta Multimedia v. WCG Clinical Serv. C.A. No. N24C-01-090 VLM CCLD., Court of Chancery of Delaware, (June 10, 2024).
Thank you for reading this blog. If you have any questions, insights, or if you’d like to engage in a more detailed discussion on this matter, I invite you to reach out directly.
Feel free to send me an email. I value thoughtful discussions and am always open to connecting with business owners, management, as well as professionals who share an interest in the complexities of M&A law.
By John McCauley: I write about recenegal problems of buyers and sellers of small businesses.
Email: jmccauley@mk-law.com
Profile: http://www.martindale.com/John-B-McCauley/176725-lawyer.htm
Telephone: 714 273-6291
Podcasts https://www.buzzsprout.com/2142689/12339043
Check out my books: Buying Assets of a Small Business: Problems Taken From Recent Legal Battles and Selling Assets of a Small Business: Problems Taken From Recent Legal Battles
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