Case demonstrates the risk of a seller of a business runs in agreeing to deferred purchase price in form of royalties

Between 1987 and 1999, Seller developed two software products. Both programs were designed to assist pharmaceutical companies and other related industries regulated by the Food and Drug Administration to comply with reporting and record-keeping obligations.

Buyer was founded in 1997 and was still a start-up company with one viable product, which was substantially similar to one of Seller’s software products, when Buyer executives approached Seller about developing and selling Seller’s software. Ultimately, on February 23, 1999, Buyer and Seller entered into an asset purchase agreement by which Buyer purchased Seller’s software. Under the terms of the asset purchase agreement, Seller was to receive a percentage of future sales and royalty payments.

In 2001, according to Seller, Buyer executives persuaded him to amend the asset purchase agreement by implying that Buyer would develop its own version of one of Seller’s software products unless Seller cooperated and agreed to amend the asset purchase agreement. He was informed that one of Seller’s software sales were low and that most of the revenue came from the sale of Buyer’s software and not Seller’s software. The asset purchase agreement, as amended, further reduced Seller’s royalty payments.

In 2003, Buyer and Buyer’s New Owner announced that Buyer’s New Owner was in the process of acquiring Buyer’s stock, and that transaction closed in early 2004. Shortly after the closing, in February of 2004, Seller sent an email to Buyer, accusing Buyer of underpaying him in an amount Seller estimated to be in the low seven-figure range, plus interest.

Seller’s email attributed the underpayments to intentional fraud and a Buyer executive team and sales force that had a bad reputation with Buyer’s customer base. Seller claimed that the problems with Buyer’s organization were never disclosed to Buyer before he sold Buyer his software.

Payments continued at much lower levels than Seller expected, and Seller’s request of Buyer for an explanation went unanswered. Finally, in 2006, Buyer’s New Owner conducted an internal audit, which revealed that Buyer had used certain tactics to boost sales of Buyer’s software product to Seller’s detriment. The audit also disclosed that Buyer’s New Owner would have to change certain practices to fully comply with the asset purchase agreement. However, nothing changed, and the dispute between Seller and Buyer’s New Owner continued.

Eventually, in October of 2008, Buyer and Seller executed an agreement tolling the statute of limitations relating to Seller’s claims. Soon after the tolling agreement was signed, Buyer’s New Owner provided Seller with 4,000 pages of sales records covering the period from 1999 to 2004. According to Seller, these records demonstrated that Buyer fabricated Buyer’s software sales and gave away free or unlicensed copies of Seller’s software. Seller claimed that that the sales records disclosed that Buyer fraudulently recorded Seller’s software product customers as having paid for purchases of Buyer’s software that the customers did not want or need. Buyer also sold copies of Seller’s software to numerous customers, but falsely designated those as sales of Buyer’s software. In addition, Buyer inflated Buyer’s software’s sales to fabricate demand for Buyer’s software and deprive Seller of sales royalties from software. And, Buyer failed to develop or sell one of Seller’s software products.

Seller asserted that Buyer’s New Owner continued these same sales and reporting practices after it acquired Buyer. Ultimately, on September 23, 2016, Seller sent Buyer’s New Owner a lengthy demand letter, which included an offer to settle the claims.

The demands were not met, and the offer to settle was declined. Seller then sued Buyer in a Massachusetts state court for fraud.

Seller lost his lawsuit against Buyer for allegedly making fraudulent promises during 1998/1999 negotiations of the Seller/Buyer deal concerning the payment of royalties and in failing to disclose the alleged bad reputation Buyer’s executive team and sales force had with Buyer’s customer base. Seller lost this fraud claim because he waited too long. Seller had 3 years to sue after he discovered the alleged fraud, and trial court concluded that Seller discovered the fraud around February of 2004. Seller appealed and the trial court’s decision was upheld by the appellate court.

But, Seller’s claims for Buyer’s post-closings misrepresentations were not dealt with by the state court. Instead they were transferred to a Massachusetts federal district court for resolution.

This case is referred to Kelly v. Waters Corporation, No. 18-P-58, Appeals Court of Massachusetts, (February 15, 2019).

Comment. This case demonstrates the risk a seller of a business runs when it takes a portion of the purchase price in the form of an earnout or royalty. In that case the seller is relying on the buyer to make his earnout or royalty. The risk is that the buyer is not motivated to do so or is willing to manipulate the books to minimize the payout, or both.

By John McCauley: I help businesses minimize risk when buying or selling a company.

Email: jmccauley@mk-law.com

Profile:            http://www.martindale.com/John-B-McCauley/176725-lawyer.htm

Telephone:      714 273-6291

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