Preliminary legal skirmish highlights risks of using earnouts.
M&A Stories
May 22, 2023
Introduction:
In the world of business acquisitions, it is common for buyers and sellers to struggle to agree on a purchase price. One approach to address this issue is by incorporating an earnout, which ties a portion of the purchase price to the post-closing performance of the business. However, as illustrated by this case, earnouts can introduce risks that should not be overlooked.
The Background:
In 2013, the seller developed an ocular allergy testing system intended for sale to ophthalmology offices. A few years later, the seller and the buyer entered into an asset purchase agreement. The agreement set the purchase price at $1.00, with the potential for additional earnouts totaling up to $24 million based on the achievement of six milestones. The buyer committed to using commercially reasonable efforts to promote, market, and sell the allergy testing system.
The buyer initially paid the seller $1 million for the first milestone achieved, but subsequently, no further earnout payments were made.
The Lawsuit:
The seller initiated legal action against the buyer, alleging that the buyer failed to use commercially reasonable efforts in marketing, promoting, and selling the allergy testing system. In response, the buyer filed a motion for summary judgment, seeking the dismissal of the seller’s claim.
The buyer argued that it had implemented various measures to promote the system, such as advertising, marketing campaigns, and the establishment of a sales team. They also pointed out their use of external agencies for advertising and marketing, as well as the creation of a customer service protocol. The buyer contended that the lack of success in adopting and utilizing the product by ophthalmology practices was the primary reason for the lower sales.
The seller, on the other hand, claimed that the buyer’s efforts fell short of what is considered commercially reasonable. They pointed to factors such as the size and effectiveness of the sales force, the training and compensation of salespersons, and the buyer’s failure to enforce the distributor agreement with a crucial supplier.
Both parties presented conflicting factual and expert testimony to support their arguments. As a result, the court denied the buyer’s motion for summary judgment, stating that there was a genuine dispute regarding the extent of commercially reasonable efforts made by the buyer.
See Doctors Allergy Formula, LLC v. Valeant Pharmaceuticals International, 2023 NY Slip Op 50469(U), Supreme Court, New York County (Decided May 12, 2023) https://scholar.google.com/scholar_case?case=15201497282621246035&q=%22asset+purchase+agreement%22&hl=en&scisbd=2&as_sdt=2006&as_ylo=2022
Comment: This case serves as a reminder of the risks involved when relying on earnouts as part of a business transaction. By accepting a minimal upfront payment and relying on earnouts, sellers place significant trust in buyers to achieve the necessary performance levels. Conversely, buyers face the possibility of costly legal disputes if earnout targets are not met.
To mitigate the risks associated with disputes over commercially reasonable efforts, it may be advisable for parties to specify marketing and sales budgets within the agreement.
By John McCauley: I write about recent legal problems of buyers and sellers of small businesses.
Email: jmccauley@mk-law.com
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