Target was a privately held public relations firm based in Darien, Connecticut, 37 miles northeast of New York City. Buyer is a New York City based brand marketing and production studio.
In August of 2016, Buyer purchased all of Target’s stock from Seller and her husband. The deal was evidenced by two agreements: a stock purchase agreement and an employment agreement.
The stock purchase agreement provided that Seller would receive yearly earn-out payments for the first two years after the stock sale, which earn-outs would amount to a percentage of yearly net revenues from existing Target clients. The stock purchase agreement obligated Buyer not to take any action which had the direct or indirect purpose of deferring revenues or otherwise improperly reducing the net revenues of Target’s clients.
The stock purchase agreement also required Buyer to hire and maintain the employment of certain existing Target employees and enter into a consulting agreement with a specific Darien, Connecticut business acceleration group.
About 9 months after the closing, Buyer’s CEO sent Seller a letter stating in substance that the acquisition was not working, pointing to Seller’s “fiercely territorial management style”. The letter said that if Seller was unwilling to discuss a termination of their agreement, Buyer would make drastic changes based on profitability. Among the promised changes were dissolving all aspects of Target, eliminating employees, including the entire interactive team, terminating the consulting agreement with the business accelerator firm, and replacing Seller.
Buyer implemented all changes within a month of sending the letter, except replacing Seller. Two months later Seller resigned.
Seller sued Buyer claiming that Buyer improperly reduced target client net revenues by isolating Seller from her employees and the clients. These actions, Seller claimed, prevented Seller from receiving her annual earn-out payments equal to a percentage of yearly net revenues from target clients. Furthermore, Seller claimed that Buyer breached its obligation to not take any action which has the direct or indirect purpose of deferring revenues or otherwise improperly reducing Target client net revenues.
Buyer argued that the actions of Buyer if true, did not amount to a breach of the stock purchase agreement.
The court disagreed, noting that the stock purchase agreement expressly prohibited Buyer from taking action to improperly reduce Target client net revenues and provided that Seller’s yearly earn-out payments was calculated entirely based on that revenue.
This case is referred to as Hoffman v. Nutmeg Music Inc., Civil Action No. 3:17-cv-01848(VLB), United States District Court, D. Connecticut (September 18, 2018).
Comment. Another case demonstrating the risk of a seller of a business taking part of the purchase price in an earnout
Seller won a very important early battle. However, Seller will still have to go through the stress, time and expense of litigating this case. Furthermore, there is always the risk that a buyer may file for bankruptcy.
The alternative to the earnout is to get your money at closing—if you have the bargaining power.
By John McCauley: I help people start, grow, buy and sell their businesses.
Telephone: 714 273-6291
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