Seller of business learns lesson about risks in an earn out

Today I want to talk about a seller of a business who learns how buyer’s problems can hurt his chances of receiving an earn out. Our story is drawn from a case that was tried before the nation’s oldest business court, the Delaware Court of Chancery. In the words of the Court:

In the early 1990s, John … saw a business opportunity in society’s growing awareness that thorough hand washing limits the spread of germs. … (T)he consensus view among reputable health authorities calls for at least a twenty second wash.

In addition to the general hand-washing trend, … (John) … perceived a lack of specialized hand-washing products for children. To fill the void, he developed a soap dispenser that leaves a small spot of ink on a child’s hand that only can be removed after twenty seconds of hand washing. He named the product “Squid Soap.”

… A consumer product paradise beckoned with high recurrent sales and patent-protected margins. All Squid Soap needed was a nationwide marketing platform and brand-name recognition.

John sold Squid Soap products through a company we shall call Seller. At this point a company we will call Buyer approached John about helping him grow Squid Soap products:

… (Buyer) … repeatedly touted what she described as … (Buyer’s) … marketing prowess, positive brand-name recognition, and the resulting opportunities for joint marketing of Squid Soap under (…Buyer’s) … brand. …

Like Squid Soap,… (Buyer) …started out as a small, single-product company focused on stopping the spread of germs. Buyer’s initial product was a cocktail of various vitamins, herbs and other ingredients that… (Buyer) …marketed as preventing and even curing the common cold.

By 2006, propelled by celebrity endorsements and aggressive advertising,… (Buyer) …ranked at the top of a list of the fastest-growing privately held companies. It experienced furious growth and at one time projected $300 million in annual sales…. (Buyer) …was at the pinnacle of brand recognition. …

So, John agreed to sell his Squid Soap assets for $1 million in cash at closing, plus the potential for earn-out payments of up to $26.5 million if certain targets were achieved. …”

The deal closed on June 25, 2007. However, the deal went bad for John and he never received any of the earn out. The most important reason for this was that Buyer did not disclose to John some very serious legal problems it was facing when it bought the Squid Soap assets:

(A)t the time… (Seller) …entered into the… (asset purchase agreement) …,… (Seller) …did not know that … (Buyer’s) … product had been severely criticized by a special investigation conducted by ABC News and aired on Good Morning America. The special report found that the clinical study on which … (Buyer)_ …based its germ-fighting claims had been produced by a “two-man operation started up just to do the … (Buyer)_ …study.” The news report led to intense scrutiny of … (Buyer’s) … products, marketing, and claims.

Squid Soap also says it did not know then that there was a class action pending against … (Buyer)_ …in California state court, filed in May 2006, which asserted various claims for false or misleading advertising, consumer fraud, deceptive or unfair business practices, concealment, omission, and unfair competition (the “California Action”). The Center for Science in the Public Interest, a non-profit organization with significant expertise in litigation over product mislabeling, joined the California Action on the plaintiffs’ side. The Center’s litigation director called the case a “great opportunity for CSPI to participate in a major lawsuit against one of the biggest supplement frauds in the country.”

In March 2008, nine months after signing the… (asset purchase agreement) … with Squid Soap, … (Buyer)_ …settled the California Action for $23.5 million. … (Buyer)_ …also agreed to place ads offering rebates in ubiquitous magazines such as Better Homes & Gardens, Parade, People, and Newsweek.

The settlement spawned a maelstrom of media attacks on … (Buyer) … Newspaper articles, television reports, and internet postings bashed … (Buyer)_ …for its bogus advertising debacle. … (Seller quotes) …  from a series of reports and single out comments like “… (Buyer) … is essentially an overpriced, run-of the-mill vitamin pill that’s been cleverly, but deceptively, marketed.” Another states that “now everyone is aware that … (Buyer)_ …is marketed through deception.” In another example: “The company’s claims had no competent, scientific support…. And even worse, the company failed to adequately warn vulnerable consumers, such as pregnant women, of potential health risks.” …

Government regulators got in on the act. The Federal Trade Commission (“FTC”) and the Attorneys General for thirty-two states sued … (Buyer)_ …and its founders for the false marketing. … (Buyer)_ …eventually agreed to a $30 million settlement with the FTC and a $7 million settlement with the Attorneys General, escrowed another $6.5 million for additional consumer claims, and committed to completely revamp its marketing program. As part of the FTC settlement, … (Buyer)_ …agreed to send a “Government Ordered Disclosure” to all of its distributors, resellers and retailers which recited that the FTC had charged … (Buyer)_ …with “making deceptive claims for … (Buyer)_ …Effervescent Health Formula and other … (Buyer)_ …branded products” and that “[a]ccording to the FTC, [Airborne] lacked scientific evidence that [its] products prevent colds, protect against germs,… or protect against colds….”

Squid Soap contends that at the time of the Asset Purchase, … (Buyer)_ …not only knew about the California Action but also knew that the regulators were on its trail…. (Seller) …alleges that on March 8, 2005, the FTC issued a “matter initiation notice” and on February 22, 2007, issued a “civil investigation demand” regarding its investigation of possible violations by … (Buyer) …

… (Buyer’s) … (post closing) … problems immediately became Squid Soap’s problems because … (Buyer)_ …owned Squid Soap and because Squid Soap had been repackaged as “Squid Soap by … (Buyer) …” Squid Soap alleges that Airborne’s difficulties “killed Squid Soap in its infancy.”

Buyer was not required by the asset purchase agreement to disclose to Seller any of its legal problems; even though the asset purchase agreement required Seller to disclose any legal problems that it had. This is interesting given that both Buyer and Seller were represented by major law firms.

The result is that Seller could not sue Buyer for not telling Seller about all of its legal problems. I doubt that John would have done the deal with Buyer had the asset purchase agreement required Buyer to disclose its legal problems and Buyer complied. And if Buyer did not disclose under those circumstances, then John would have had a good lawsuit against Buyer for failure to disclose.

This Delaware Court of Chancery case is referred to as Airborne Health, Inc. v. Squid Soap, LP , 984 A. 2d 126 – Del: Court of Chancery 2009 and can be found at: https://scholar.google.com/scholar_case?case=8822139974870760604&q=%22asset+purchase+agreement%22&hl=en&as_sdt=806000000000001e00c000000000003c00000000000000000000000010a0e0f2000400002141c300100000000000002004

Comment. So, one lesson learned is that if you are a seller and you are getting an earn out, you will want to have buyer make lots of representations and warranties about the buyer, so you know if you want to deal with the buyer. Second, this case illustrates the value of due diligence. John’s team should have figured out enough of Buyer’s problems by checking Buyer out.

By John McCauley: I help people start, grow, buy and sell their businesses.

Email:        jmccauley@mk-law.com

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

Telephone:      714 273-6291

 

Posted in due diligence, earn outs, representations and warranties

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