A prospective buyer and seller of a business often can’t agree upon a purchase price. One way to bridge the gap is to break down the purchase price into two pieces. A fixed amount and a contingent amount based upon the performance of the business after the closing.
The contingent amount is called an earnout in the trade. The earnout portion of the purchase price is often calculated as a share of the postclosing profits of the business.
In this case, the business provided pharmaceutical products, supplies, and consultation services to long-term care facilities in New Mexico. In 2013 the buyer and seller entered into an asset purchase agreement that contained an earnout.
The earnout was based upon the gross profits of the business during the period between the first and 2nd anniversary of the closing. The earnout would be $1.25 million if the gross profits from the customers of the business that stayed with the buyer through the 2nd anniversary of the closing was at least $2.2 million. The earnout would be reduced according to a formula if such gross profits were between $2.2 million and $1.87 million. No earnout would be earned if gross profits were less than $1.87 million.
At the end of the 2nd anniversary of the closing the buyer told the seller that the business had missed the minimum gross profits target by $649K; meaning that there was no earnout. The seller sued the buyer and the lawsuit ended up in a New Mexico federal district court.
The seller accused the buyer of sabotaging the business’ customer accounts, causing customers to terminate their contracts with the buyer before the two-year anniversary; and thus, depriving the seller of his earnout. The seller said that the buyer violated an implied duty of good faith and fair dealing under applicable Delaware law by managing the accounts it purchased from the seller so poorly that clients terminated their accounts and reduced the seller’s chances of earning the deferred payment.
The buyer asked the court to throw the lawsuit out in its motion for summary judgment; claiming that it made no economic sense for the buyer to sabotage customer accounts just to avoid paying a portion of the gross profit to the seller. The buyer argued broadly that the seller had not presented any facts that create a genuine dispute over whether the buyer managed the accounts in good faith, and thus his claim must fail.
The court, however, said that the seller should have his day in court because the seller had made enough specific allegations of buyer behavior to create a genuine factual dispute about the buyer’s good faith; and that justifies permitting the seller to continue its lawsuit against the buyer.
Specifically, the seller produced evidence from an employee of one of the seller’s largest customers who terminated its relationship with the buyer before the 2nd anniversary of the closing. That employee talked about many problems that her company had with the buyer’s performance; and as a result, her company terminated its account with the buyer
Also, the court pointed to the evidence from a pharmacy consultant that worked both with seller and then the buyer. She said that in the time that she worked for the buyer, she observed problems relating to the buyer’s billing, delivery of medications, pricing for medications, and keeping of medical records.
This case is referred to Huntingford v. Pharmacy Corporation Of America, No: 1:17-cv-1210-RB-LF, United States District Court, D. New Mexico, (March 1, 2019).
The risk of agreeing to an earnout is that the seller is relying upon the buyer to make the earnout happen. And when it does not; a lawsuit is an uphill battle.
By John McCauley: I help businesses minimize risk when buying or selling a company.
Telephone: 714 273-6291
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