Buyer, with headquarters in Wichita, Kansas, is in the business of providing services and products to companies in the recreational vehicle (`RV”) industry. Target is based in the greater Dallas-Fort Worth area and specializes in manufacturing and selling window shades to dealers, retailers and original equipment manufacturers in the RV industry.
In 2016, Buyer began negotiations with Shareholder (founder and part owner of Target) for the acquisition of Target. These negotiations eventually led to a stock purchase agreement, dated as of September 1, 2016.
During the negotiations, one point of disagreement concerned the purchase price: Target sought $20 million, and Buyer wanted to pay $4 million less, or $16 million. An earn-out payment was agreed upon as a way of closing this gap. Under the earn-out part of the deal, Buyer agreed to make an additional payment of up to $5.6 million to Shareholder, only if certain adjusted EBITDA targets were met.
Shareholder explicitly conceded that no earn-out payment was guaranteed. Notably, the stock purchase agreement did not contain any commitments or agreements of any kind by Buyer to operate Target in any particular manner, including with regard to the number or identity of sales personnel.
One month following its acquisition of Target, Buyer announced a second acquisition — which included a company that competed directly with Target. No provision of the stock purchase agreement prohibited such a transaction and indeed, certain provisions anticipated that one is possible.
Following the closing, Buyer took over the operations of Target. Over the course of 2016, Target’s revenues were lower than what Buyer had anticipated, or Shareholder hoped. As of year-end 2017, Target had failed to achieve the adjusted EBITDA targets to trigger any earn-out payment.
On February 16, 2018, Shareholder sued Buyer, under several legal theories. The first claim was that Buyer fraudulently induced Shareholder to agree to the deal by selling the earn-out concept; telling Shareholder what actions Buyer would take to help achieve the adjusted EBITDA targets; actions which Buyer did not take after the closing.
Specifically, Shareholder claimed that Buyer told him that Buyer intended to hire a new full-time salesperson and would devote its salesforce to selling Target’s products; that it would supply engineering assistance to enable Target to launch new products; that it would allow Target to take advantage of is freight and shipping network; and that it would expand Target’s product lines and commercial and distributor markets.
Furthermore, Shareholder said that Buyer failed to disclose to him Buyer’s pending acquisition of a competitor; an acquisition that closed one month after Shareholder sold his stock to Buyer.
Buyer argued that Shareholder cannot bring a fraud claim against Buyer because Shareholder agreed in the stock purchase agreement that Shareholder would only rely on promises made by Buyer in the stock purchase agreement; and these alleged Buyer promises were not contained in the stock purchase agreement. The court agreed.
Shareholder also charged Buyer with not operating Target in a manner that would maximize the opportunity for Target to meet the targets triggering the earn-out payment. Specifically, Shareholder argued that Buyer breached the stock purchase agreement provision prohibiting Buyer from taking actions in bad faith with the intent and effect of avoiding or reducing the earn-out.
The court permitted Shareholder to pursue this legal claim. It noted though that Shareholder will not only have to prove bad faith, but just as importantly, prove that Buyer’s actions in fact deprived Shareholder of an earn-out payment. The litigation is at an early stage and Shareholder will have to develop its case through discovery.
This case is referred to as Townsley v. Airxcel, Inc., No. 18-cv-1439 (KBF), United States District Court, S.D. New York (August 15, 2018).
Comment. Earn-outs are risky. In this case, Shareholder would have been in a better position if Buyer’s promises made about post-closing actions would have been included in the stock purchase agreement.
Also, with hindsight, Shareholder could have asked Buyer to make a promise in the stock purchase agreement that it would not acquire a competitor during the earn-out period.
By John McCauley: I help people start, grow, buy and sell their businesses.
Telephone: 714 273-6291
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