Disappointing earnout deals are common.
This deal involved the stock acquisition of the target, a legal analytics company by a competitor. The price was $9 million cash plus a $3 million earnout potential. The earnout was based upon hitting certain revenue thresholds over the first two years following the closing.
While the parties were negotiating the level at which the threshold would be set, the buyer presented the sellers with various projections regarding the buyer’s ability to earn certain revenue amounts. The buyer pitched the projections, which according to the sellers depended on the buyer’s commitment and ability to add new target customers as well as its own stability, as “conservative.” But the projections were in fact quite aggressive; relatedly, and unbeknownst to the target shareholders, the revenue earned by the buyer’s business had fallen almost 50% from the first quarter of 2014 to the fourth quarter.
As negotiations neared completion in December 2014, the sellers e-mailed the buyer leadership to confirm that the companies’ objectives with respect to achieving the earnouts were aligned. The buyer, making no mention of its financial condition, responded that it was “committed at all times to making sure we have the tightest alignment possible for every objective we pursue.”
The buyer and sellers signed a stock purchase agreement on January 8, 2015. The buyer and one of the target’s sellers (the target’s co-founder and CEO) also signed a separate master subcontractor agreement and statement of work outlining a variety of post-acquisition services the target CEO would provide to the buyer.
After the deal closed, the buyer paid the initial purchase price but did not focus on selling the target products and made little effort to achieve the revenue threshold necessary to trigger the earnout payments. During the first earnout period, Buyer delivered less than 20% of its projected revenue amount. Further, the buyer never engaged the target’s CEO to perform post-closing services despite his requests to do so. Then, in December 2015 (less than a year after the acquisition and a few months before the first earnout period ended), the buyer sold its legal division (which included the target) to a competitor, which had no interest in the target’s product.
The post-closing performance of the business did not generate an earnout. The seller sued the buyer in an Illinois federal district court for fraudulently inducing the target shareholders into entering the stock purchase agreement by making false representations about the buyer’s intentions and ability to achieve the earnout payments, in violation the Illinois Securities Law and Illinois common law.
The buyer argued that the shareholders failed to allege facts showing that they were entitled to relief under either the Illinois Securities Law or Illinois common law and asked the court to dismiss the lawsuit. The court concluded that the above alleged facts state a fraud claim under both the Illinois Securities Law and Illinois common law.
This case is referred to as Gruner v. Huron Consulting Group, Inc., No. 18 CV 02143, United States District Court, N.D. Illinois, Eastern Division (August 12, 2019)
The court made several observations about Illinois law with respect to two common boilerplate provisions found in M&A documents. An integration clause which was in this stock purchase agreement and an anti-reliance clause which was not.
The stock purchase agreement’s integration clause stated that the agreement set forth the entire understanding of the parties with respect to the transaction and superseded any other agreements and representations. Nevertheless, under Illinois law, this standard integration provision would not protect the buyer from fraudulent representations or omissions, such as the buyer’s aggressive projections.
On the other hand, an anti-reliance provision would have changed the result in this case. In that clause the target shareholders would have contractually promised the buyer that they did not rely upon statements of the buyer made outside the stock purchase agreement’s four corners in deciding to sign the SPA.
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