Operational Clarity: Protecting Earnouts Beyond Financial Targets in Lower Middle Market M&A

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Beyond Financial Targets: How Operational Clarity Protects Earnouts in Lower Middle Market M&A. Learn from a recent case highlighting the crucial need to address post-closing operational control in deal agreements to minimize litigation risks for buyers, sellers, and advisors.

M&A Stories

April 17, 2025

Earnouts are a prevalent mechanism in lower middle market private equity deals, designed to align seller incentives with post-closing performance, typically tied to achieving specific financial targets. However, a recent California appellate decision highlights a critical, often underestimated factor: the buyer’s post-closing operational control and its potential to impact the seller’s ability to achieve those financial goals. For sophisticated M&A players, the lesson extends beyond standard “reasonable efforts” clauses, underscoring the tangible impact of integration decisions on the realization of earnout targets.

The dispute arose after the buyer acquired a concierge service for moving homeowners that generated revenue primarily through referrals from utility companies. The asset purchase agreement included an earnout based on the acquired business’s future revenue. A key point of contention in the subsequent litigation was the seller’s allegation that post-acquisition, the buyer directed the seller to expand its relationship with Updater, who had been a significant source of revenue for the seller, despite the fact that revenue from Updater was explicitly excluded from the earnout calculation. The seller claimed this hindered its ability to meet the earnout targets.

This case highlights the risk of acquisition agreements lacking specifics on the buyer’s post-closing operational priorities. To mitigate this, the seller could have sought a buyer covenant stating that during the earnout period, the buyer would not direct the seller to prioritize business with entities whose revenue is excluded from the earnout calculation. This type of clear prohibition would prevent the buyer from actively steering the seller towards activities that don’t generate earnout revenue, ensuring the seller’s focus remains on the core business drivers of the earnout.

For sellers and their advisors, recognizing the potential for the buyer’s operational decisions to impact earnout achievement is crucial. Proactive negotiation of specific, yet concise, provisions addressing the direction of post-closing operational priorities can serve as a vital safeguard. This approach, directly informed by the costly lessons of this case, fosters better alignment of interests and mitigates the risk of post-closing actions unintentionally – or intentionally – derailing the earnout, ultimately contributing to more successful and less contentious transactions in this critical segment of the M&A landscape.

See: Porch. Com, Inc. v. Kandela, LLC,  No. B326289, Court of Appeals of California, Second District, Division Seven, (April 14, 2025).

Thank you for reading this blog. If you have any questions, insights, or if you’d like to engage in a more detailed discussion on this matter, I invite you to reach out directly.

Feel free to send me an email. I value thoughtful discussions and am always open to connecting with business owners, management, as well as professionals who share an interest in the complexities of M&A law in lower middle market private target deals..

By John McCauley: I write about recent problems of buyers and sellers in lower middle market private target deals.

Email: jmccauley@mk-law.com

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

Telephone:      714 273-6291

Check out my books: Buying Established Business Assets: A Guide for Owners, https://www.amazon.com/dp/B09TJQ5CL5

and Advisors and Selling Established Business Assets: A Guide for Owners and Advisors, https://www.amazon.com/dp/B0BPTLZNRM

 

Legal Disclaimer

The blogs on this website are provided as a resource for general information for the public. The information on these web pages is not intended to serve as legal advice or as a guarantee, warranty or prediction regarding the outcome of any particular legal matter. The information on these web pages is subject to change at any time and may be incomplete and/or may contain errors. You should not rely on these pages without first consulting a qualified attorney.

Posted in problems with earnouts Tagged with: , , , , , , , ,

Speed vs. Scrutiny: The Perils of Rushed Due Diligence in Lower Middle Market M&A

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Don’t let a fast close lead to costly M&A disputes. This blog provides actionable legal insights for lower middle market buyers, sellers, and advisors on how robust pre-closing steps – from due diligence to contractual protections – can safeguard your transactions and prevent future litigation.

M&A Stories

April 16, 2025

The allure of a swift transaction can be strong in the lower middle market, but as a recent New York Supreme Court case illustrates, prioritizing speed over thoroughness can lead to costly disputes down the line. This case involved the asset sale of a web hosting business where the seller alleged the buyer emphasized a rapid closing (within 4-5 weeks) and claimed independent verification of the seller’s EBITDA. Based partly on this promise, the seller accepted the buyer’s offer, potentially foregoing other interested parties with higher bids. However, post-closing, the buyer allegedly reneged on the agreed-upon purchase price, triggering litigation and counterclaims of fraudulent inducement from the seller.

The Takeaway: While a quick closing can be a significant deal driver, particularly for sellers seeking liquidity or buyers aiming to capitalize on a perceived opportunity, it should never supersede rigorous pre-closing due diligence. In this instance, the seller alleged that the buyer’s emphasis on speed, coupled with representations about their independent financial assessment, influenced their decision to proceed. The subsequent dispute suggests the buyer might have prioritized expediency, potentially leading to incomplete or flawed due diligence regarding the business’s financials.

The Recommendation: For both sophisticated buyers and sellers in the lower middle market, the pressure of a quick close necessitates heightened vigilance, not rushed processes.

For Buyers & Their Advisors: Resist the urge to shortcut standard due diligence procedures, regardless of the seller’s timeline pressures or your own desire for a swift acquisition. Implement internal protocols that mandate a minimum level of scrutiny. Meticulously document the basis of the purchase price in the Asset Purchase Agreement (APA), clearly referencing the agreed-upon valuation methodology and the specific financial information relied upon. Do not rely on verbal assurances, especially concerning financial calculations. If a seller emphasizes your “independent calculations,” demand full transparency into their methodology and underlying data. Reconcile these findings with standard accounting practices and your own thorough analysis. Ensure robust integration clauses are in place, clearly stating the APA constitutes the entire agreement and supersedes prior discussions.

For Sellers & Their Advisors: While a quick close is attractive, prioritize providing comprehensive and well-documented information upfront. This can expedite the buyer’s diligence without creating suspicion or grounds for future disputes. Be realistic about the buyer’s need for due diligence, even in a fast-paced deal. Resist the urge to pressure buyers into skipping crucial steps. Work closely with legal counsel to precisely define the scope and limitations of your representations and warranties in the APA, especially concerning financial information.

In conclusion, while speed can be a valuable asset in M&A, it should be a carefully managed factor, not a justification for compromising thorough pre-closing due diligence. As this case suggests, prioritizing a quick close without a solid understanding of the underlying business can ultimately lead to protracted and expensive disputes.

See: World Host Group US Inc. v. O’Cloud Ventures, LLC Index No. 654128/2023, Motion Seq. No. 003, Supreme Court, New York County, (April 1, 2025).

https://scholar.google.com/scholar_case?case=16563193979159182353&q=%22asset+purchase+agreement%22&hl=en&scisbd=2&as_sdt=2006&as_ylo=2022

Thank you for reading this blog. If you have any questions, insights, or if you’d like to engage in a more detailed discussion on this matter, I invite you to reach out directly.

Feel free to send me an email. I value thoughtful discussions and am always open to connecting with business owners, management, as well as professionals who share an interest in the complexities of M&A law.

By John McCauley: I write about recenegal problems of buyers and sellers of small businesses.

Email: jmccauley@mk-law.com

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

Telephone:      714 273-6291

Check out my books: Buying Established Business Assets: A Guide for Owners, https://www.amazon.com/dp/B09TJQ5CL5

and Advisors and Selling Established Business Assets: A Guide for Owners and Advisors, https://www.amazon.com/dp/B0BPTLZNRM

 

Legal Disclaimer

The blogs on this website are provided as a resource for general information for the public. The information on these web pages is not intended to serve as legal advice or as a guarantee, warranty or prediction regarding the outcome of any particular legal matter. The information on these web pages is subject to change at any time and may be incomplete and/or may contain errors. You should not rely on these pages without first consulting a qualified attorney.

Posted in Problems with due diligence Tagged with: , , , , , , , , , , , , , , , , , , , , , , , , , ,

Unseen Ties: Mitigating Conflict of Interest Risks in M&A Vendor Relationships

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Navigate the complexities of M&A with insights into mitigating hidden risks in vendor contracts. This article dissects a recent case highlighting the dangers of undisclosed conflicts of interest involving a target company’s insiders and key service providers. Learn practical pre-closing strategies for buyers, sellers, and advisors in the lower middle market, focusing on the crucial role of representations, warranties, and due diligence in safeguarding against post-acquisition legal disputes. Understand how to structure deals and negotiate contractual provisions to address unseen ties that could impact your M&A transactions.

M&A Stories

April 11, 2025

Unseen Ties: Mitigating Conflict of Interest Risks in M&A Vendor Relationships

Acquiring a business often entails stepping into the target’s existing operational framework, which invariably includes contracts with key vendors. However, the seemingly straightforward transfer of these agreements can be complicated by hidden affiliations, as a recent legal case illustrates. The matter underscores the critical importance of proactive measures to identify and address potential conflicts of interest involving a target company’s insiders and its essential service providers.

Consider a scenario where a buyer agreed to acquire a medical billing firm specializing in radiology services. The target company’s operations were heavily reliant on a specific software platform provided by a third-party vendor, a system integral to its core billing processes. Unbeknownst to the buyer, the target company’s chief executive officer held a significant personal financial stake in this very software vendor. This conflict of interest remained undisclosed throughout the negotiation and sale process, hidden from both the selling shareholders and the acquiring entity.

Following the agreement on acquisition terms, the software vendor initiated litigation related to the deal. The target’s CEO then played a role in facilitating a settlement, an arrangement that obligated the buyer to continue using the vendor’s platform for an extended period post-acquisition, with associated payments. Crucially, the buyer remained unaware of the CEO’s financial entanglement with this key vendor during this period.

The undisclosed conflict eventually surfaced, prompting the buyer to pursue legal action against the selling shareholders, alleging vicarious liability for the CEO’s fraudulent concealment. Ultimately, a jury sided with the sellers on this claim.

While the specifics of due diligence vary, the facts of this case suggest that standard buyer inquiries might not have unearthed the CEO’s hidden interest. However, this outcome highlights a crucial pre-closing strategy: the inclusion of a robust representation and warranty within the acquisition agreement. Buyers should insist on an explicit assurance from the selling shareholders that no owner, officer, or key employee of the target company holds any direct or indirect financial interest in any of the target’s material vendors, suppliers, or customers. A carefully crafted exception could be carved out for de minimis, passive holdings in publicly traded entities. Furthermore, the acquisition agreement should include a clear indemnification provision obligating the sellers to compensate the buyer for any losses arising from a breach of this representation.

Such a contractual provision serves as a vital safeguard, shifting the responsibility of disclosure to the sellers and providing a recourse for the buyer should undisclosed conflicts of interest materialize post-closing. While thorough due diligence remains paramount, specific and well-negotiated representations and warranties offer a critical layer of protection against hidden risks that might otherwise remain unseen until litigation ensues.

See: Zotec Partners, LLC v. Hulsey Court of Appeals Case No. 24A-PL-870, Court of Appeals of Indiana, (April 8, 2025).

Thank you for reading this blog. If you have any questions, insights, or if you’d like to engage in a more detailed discussion on this matter, I invite you to reach out directly.

Feel free to send me an email. I value thoughtful discussions and am always open to connecting with business owners, management, as well as professionals who share an interest in the complexities of M&A law.

By John McCauley: I write about recenegal problems of buyers and sellers of small businesses.

Email: jmccauley@mk-law.com

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

Telephone:      714 273-6291

Check out my books: Buying Established Business Assets: A Guide for Owners, https://www.amazon.com/dp/B09TJQ5CL5

and Advisors and Selling Established Business Assets: A Guide for Owners and Advisors, https://www.amazon.com/dp/B0BPTLZNRM

Legal Disclaimer

The blogs on this website are provided as a resource for general information for the public. The information on these web pages is not intended to serve as legal advice or as a guarantee, warranty or prediction regarding the outcome of any particular legal matter. The information on these web pages is subject to change at any time and may be incomplete and/or may contain errors. You should not rely on these pages without first consulting a qualified attorney.

Posted in Problem with Vendors and Suppliers Tagged with: , , , , , , , , , , , , , , , , , , , , , , , , , , , , , ,

The Perils of Unfinished Accounting: A Cautionary Tale for M&A Sellers

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Navigate the complexities of M&A law with insights into recent cases impacting buyers and sellers in the lower middle market. This post analyzes the PDS Acquisition v. KDHM ruling, revealing a crucial pitfall for sellers regarding the treatment of earned customer deposits in asset sales and offering actionable advice to minimize litigation risks through diligent due diligence, precise contractual language in the Asset Purchase Agreement, and proactive negotiation. Understand how seemingly standard “excluded assets” clauses can lead to unexpected financial consequences and learn how to protect your interests in lower middle market M&A deals.

M&A Stories

April 6, 2025

In lower middle market asset sales, sellers often retain cash as an “excluded asset.” However, the treatment of customer deposits – advance payments for future goods or services – can be a surprising source of M&A disputes. A recent Texas case, PDS Acquisition, Corp. v. KDHM, LLC, highlights a critical pitfall for sellers regarding these deposits.

The 2020 sale of a printing business hinged on the definition of excluded customer deposits, which were defined as those “not been earned and offset against seller’s accounts receivable prior to closing.” Despite the seller, KDHM, having already earned some deposits by completing the work, the failure to “offset” them in their accounting before closing led to a post-closing battle with the buyer. The buyer successfully argued that these deposits were not excluded assets.

The appellate court sided with the buyer, interpreting the agreement to require both that deposits were unearned and un-offset to be excluded. Because the deposits were earned, they were deemed part of the acquired assets, even though the seller had performed the work. This outcome underscores a crucial lesson for sellers: the specific wording of the Asset Purchase Agreement (APA) regarding excluded assets, particularly customer deposits, carries significant weight.

Economically, the seller likely believed they should retain cash for work already completed. However, the APA’s requirement for the “offset” accounting step to be finished before closing proved decisive. This case serves as a clear warning to sellers and their advisors in the lower middle market to proactively address the treatment of customer deposits with precision in the APA.

To minimize the risk of such disputes, sellers should advocate for straightforward language defining excluded customer deposits based on whether the related work and revenue recognition occurred before closing, without adding conditions tied to the completion of specific accounting procedures like the “offset.” Clear drafting, thorough pre-closing due diligence on both sides regarding deposit accounting, and open negotiation about which deposits will be retained are essential steps to avoid unintended transfers of value and potential post-closing litigation.

See: PDS Acquisition, Corp. v. KDHM, LLC No. 04-24-00358-CV, Court of Appeals of Texas, Fourth District, San Antonio, (April 2, 2025).

Thank you for reading this blog. If you have any questions, insights, or if you’d like to engage in a more detailed discussion on this matter, I invite you to reach out directly.

Feel free to send me an email. I value thoughtful discussions and am always open to connecting with business owners, management, as well as professionals who share an interest in the complexities of M&A law.

By John McCauley: I write about recenegal problems of buyers and sellers of small businesses.

Email: jmccauley@mk-law.com

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

Telephone:      714 273-6291

Check out my books: Buying Established Business Assets: A Guide for Owners, https://www.amazon.com/dp/B09TJQ5CL5

and Advisors and Selling Established Business Assets: A Guide for Owners and Advisors, https://www.amazon.com/dp/B0BPTLZNRM

Legal Disclaimer

The blogs on this website are provided as a resource for general information for the public. The information on these web pages is not intended to serve as legal advice or as a guarantee, warranty or prediction regarding the outcome of any particular legal matter. The information on these web pages is subject to change at any time and may be incomplete and/or may contain errors. You should not rely on these pages without first consulting a qualified attorney.

Posted in Earned customer deposits, Excluded Assets Tagged with: , , , , , , , , , , , , , , , , , , , , , , , , , ,

Beyond the Lease: Understanding Third-Party Restrictions in M&A Deals

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Navigate the complexities of M&A deals involving leased properties. This insightful blog post dissects the In re Big Lots, Inc. case, revealing the hidden risks lurking beyond the standard lease agreement. Learn how buyers, sellers, and advisors in the lower middle market can proactively address third-party restrictions and avoid post-closing surprises through smarter due diligence and strategic planning.

M&A Stories

April 5, 2025

Many mergers and acquisitions in the lower middle market hinge on the smooth transfer of key assets, and for businesses with a physical presence, leases are often paramount. A recent bankruptcy case involving Big Lots and the proposed assignment of a store lease to Goodwill serves as a critical reminder that the due diligence process cannot stop at the four corners of the lease agreement itself.

The dispute arose when the landlord of the shopping center where the Big Lots store was located objected to Goodwill, a “second hand” store, taking over the lease. This objection was based on a recorded use restriction—an agreement binding the property—that prohibited such businesses. Crucially, this restriction was not mentioned within the lease agreement between Big Lots and the landlord. Ultimately, the bankruptcy court overruled the landlord’s objection, finding that the evidence presented did not conclusively prove the restriction applied to the specific Big Lots location.

This case, In re Big Lots, Inc., underscores a vital lesson for both buyers and sellers in M&A transactions involving leased real estate. While a thorough review of the lease terms is essential, it is equally important to recognize that external, recorded agreements can significantly impact the rights and obligations associated with that lease. Even when the applicability of such restrictions is not immediately clear, their existence creates potential risks.

Buyers in lower middle market deals, while often operating with resource constraints, should prioritize basic due diligence beyond the lease for key locations. This includes a search for recorded encumbrances affecting the property. The discovery of such agreements, even if their impact seems ambiguous, should prompt further inquiry. Engaging in targeted communication with the landlord to understand their perspective on any overarching property agreements and the buyer’s intended use can surface potential issues early in the process.

Sellers, for their part, should proactively identify and disclose any recorded covenants or agreements that could affect the transfer or use of their leased properties, particularly for critical locations. Transparency in this regard can facilitate a smoother transaction and mitigate the risk of post-closing disputes.

While the ambiguity in the Big Lots case ultimately favored the lease assignment, relying on such uncertainty is a precarious strategy. The case serves as a compelling reminder that a comprehensive understanding of the real estate landscape surrounding key leased assets, extending beyond the lease agreement itself, is a prudent and necessary step in minimizing the risk of unwelcome surprises in M&A transactions.

See: In Re Big Lots, Inc. Case No. 24-11967 (JKS), United States Bankruptcy Court, D. Delaware, (March 31, 2025).

Thank you for reading this blog. If you have any questions, insights, or if you’d like to engage in a more detailed discussion on this matter, I invite you to reach out directly.

Feel free to send me an email. I value thoughtful discussions and am always open to connecting with business owners, management, as well as professionals who share an interest in the complexities of M&A law.

By John McCauley: I write about recenegal problems of buyers and sellers of small businesses.

Email: jmccauley@mk-law.com

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

Telephone:      714 273-6291

Check out my books: Buying Established Business Assets: A Guide for Owners, https://www.amazon.com/dp/B09TJQ5CL5

and Advisors and Selling Established Business Assets: A Guide for Owners and Advisors, https://www.amazon.com/dp/B0BPTLZNRM

 

Legal Disclaimer

The blogs on this website are provided as a resource for general information for the public. The information on these web pages is not intended to serve as legal advice or as a guarantee, warranty or prediction regarding the outcome of any particular legal matter. The information on these web pages is subject to change at any time and may be incomplete and/or may contain errors. You should not rely on these pages without first consulting a qualified attorney.

Posted in Uncategorized Tagged with: , , , , , , , , , , , , , , , , , ,

Pennsylvania’s Broad Approach to Successor Liability in De Facto Mergers

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Explore Pennsylvania’s broad approach to successor liability in asset sales, with a focus on the de facto merger doctrine. This case study on a Pennsylvania waste management acquisition sheds light on how the state’s courts interpret continuity of ownership, even in all-cash transactions or post-closing executive management contracts. Learn how these legal nuances could impact asset buyers and what they should consider when structuring deals to avoid unexpected liabilities. Perfect for M&A professionals and business advisors, this blog highlights key insights on the legal risks surrounding asset sales and successor liability.

M&A Stories

March 4, 2025

In most states, buyers of a company’s assets can limit their liability for the seller’s debts unless they assume them explicitly or meet specific successor liability criteria. One common exception is the de facto merger doctrine, which typically requires continuity of ownership—meaning the seller’s owners receive stock in the buyer. But Pennsylvania takes a broader approach.

This case involved a 2017 asset acquisition of a Pennsylvania waste management and recycling business. The deal was all cash, with no buyer stock issued, and the seller’s owner stayed on under an executive management contract that included a bonus provision.

After closing, one of the seller’s hauling vendors sued the buyer for $120,000 in unpaid invoices, arguing that Pennsylvania’s de facto merger rule made the buyer liable. A trial court ruled in favor of the vendor, holding that the seller’s owner’s post-closing management role qualified as continuity of ownership. The appellate court disagreed, sending the case back for further proceedings but noting that Pennsylvania courts have held that even a promissory note can establish continuity of ownership.

Most states, including Delaware, California, and New York, would not consider a promissory note as continuity of ownership unless the note has equity-like features, such as being payable only from the buyer’s future cash flow or having other characteristics that make it more akin to equity than debt. Courts might also view post-closing compensation structures with incentive components as continuity of ownership. Buyers in Pennsylvania should tread carefully when structuring asset deals to avoid unintended liability for seller debts.

See: Campbell v. WeCare ORGANICS LLC No. 716 MDA 2024, Superior Court of Pennsylvania, (February 25, 2025).

Thank you for reading this blog. If you have any questions, insights, or if you’d like to engage in a more detailed discussion on this matter, I invite you to reach out directly.

Feel free to send me an email. I value thoughtful discussions and am always open to connecting with business owners, management, as well as professionals who share an interest in the complexities of M&A law.

By John McCauley: I write about recenegal problems of buyers and sellers of small businesses.

Email: jmccauley@mk-law.com

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

Telephone:      714 273-6291

Podcasts https://www.buzzsprout.com/2142689/12339043

Check out my books: Buying Established Business Assets: A Guide for Owners and Advisors and Selling Established Business Assets: A Guide for Owners and Advisors

Legal Disclaimer

The blogs on this website are provided as a resource for general information for the public. The information on these web pages is not intended to serve as legal advice or as a guarantee, warranty or prediction regarding the outcome of any particular legal matter. The information on these web pages is subject to change at any time and may be incomplete and/or may contain errors. You should not rely on these pages without first consulting a qualified attorney.

Posted in anti-destruction clause, continuity of ownership, customer list, de facto merger exception, fee based upon buyer debt assumption, implied covenant of good faith and fair dealing, no oral modifications of contract, overly complicated language in contract, success fee, successor liability, target's stock options, trade secret misappropriation, waiver of contractual provision Tagged with: , , , , , , , , , , , , , , , , , , , ,

Why Delaware’s Implied Covenant of Good Faith and Fair Dealing Is Not Enough Protection for an Earnout

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In this blog post, we explore the crucial role of earnout agreements in M&A transactions and why Delaware’s implied covenant of good faith and fair dealing is not sufficient protection for sellers. A recent Delaware Court of Chancery case underscores the importance of explicitly defining buyer obligations, especially when it comes to achieving earnout milestones. The post highlights the distinction between implied and express efforts provisions, illustrating how this misunderstanding can leave sellers vulnerable. This article provides valuable insights for M&A professionals, particularly those negotiating earnouts in private company deals.

M&A Stories

February 14, 2025

An M&A seller that agrees to a significant earnout must take great care in the earnout agreement to require the buyer to use good faith or commercially reasonable effort to hit the earnout milestones. Sellers often assume that Delaware’s implied covenant of good faith and fair dealing provides sufficient protection. But that is not the case.

A recent Delaware Court of Chancery case highlights how even experienced M&A lawyers may not fully appreciate the distinction between Delaware’s implied covenant of good faith and fair dealing and an express efforts provision in an earnout agreement. This misunderstanding can leave sellers vulnerable when a buyer fails to meet earnout milestones.

During negotiations, the seller’s lawyer wanted a provision requiring the buyer to use good faith efforts to meet the revenue milestones. The buyer’s lawyer argued that such language was unnecessary because Delaware law’s implied covenant of good faith and fair dealing already obligated the buyer to act in good faith to achieve the milestones. The court later noted that the seller’s lawyer apparently accepted that assertion without insisting on explicit language.

The revenue milestones were not met, and the seller received no earnout. The seller sued the buyer, a portfolio company of the private equity firm, in the Delaware Court of Chancery for breach of contract. The seller alleged that the buyer’s actions and inactions, including splitting the company’s flagship integrated safety and training product into two separate offerings, providing insufficient sales and marketing support, limiting new customer acquisition, failing to deliver competing product revenue that was part of the earnout calculation, and restricting the seller’s autonomy to run the company—prevented the milestones from being reached.

The seller argued that these actions violated Delaware’s implied covenant of good faith and fair dealing. The buyer moved to dismiss, and the court granted the motion. It ruled that the implied covenant serves only as a gap filler where the parties have not addressed an issue in their contract. Here, the negotiations had covered buyer efforts, so the implied covenant did not apply.

The court’s decision was correct, but the case underscores an important lesson for sellers. The buyer’s lawyer was wrong in claiming that the implied covenant provides the same protection as an express efforts provision. This case is not about the distinction between express and implied efforts covenants but serves as a springboard to highlight the higher burden a seller faces under the implied covenant. If the implied covenant had applied, the seller would have needed to prove that the buyer acted intentionally and in bad faith. In contrast, if the agreement had included an explicit good faith or commercially reasonable efforts provision, the seller’s claim would have survived the motion to dismiss. The seller would only have needed to show that the buyer’s actions or inactions failed to meet its contractual obligations—regardless of whether they were taken in good or bad faith.

See: Trifecta Multimedia v. WCG Clinical Serv. C.A. No. N24C-01-090 VLM CCLD., Court of Chancery of Delaware, (June 10, 2024).

Thank you for reading this blog. If you have any questions, insights, or if you’d like to engage in a more detailed discussion on this matter, I invite you to reach out directly.

Feel free to send me an email. I value thoughtful discussions and am always open to connecting with business owners, management, as well as professionals who share an interest in the complexities of M&A law.

By John McCauley: I write about recenegal problems of buyers and sellers of small businesses.

Email: jmccauley@mk-law.com

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

Telephone:      714 273-6291

Podcasts https://www.buzzsprout.com/2142689/12339043

Check out my books: Buying Assets of a Small Business: Problems Taken From Recent Legal Battles and Selling Assets of a Small Business: Problems Taken From Recent Legal Battles

Legal Disclaimer

The blogs on this website are provided as a resource for general information for the public. The information on these web pages is not intended to serve as legal advice or as a guarantee, warranty or prediction regarding the outcome of any particular legal matter. The information on these web pages is subject to change at any time and may be incomplete and/or may contain errors. You should not rely on these pages without first consulting a qualified attorney.

Posted in Express efforts clause vs. Delaware's implied covenant of good faith and fair dealing, problems with earnouts Tagged with: , , , , , , , , , , , , , , , , , , ,

When Does an M&A Indemnification Claim Accrue? The Difference Between First-Party and Third-Party Claims

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Understanding when an M&A indemnification claim accrues is critical for buyers and sellers in private company transactions. This blog explores a Delaware case that clarifies the distinction between first-party and third-party indemnification claims and how survival provisions impact post-closing disputes. Learn how the timing of claims can extend beyond closing, affecting deal negotiations and risk allocation.

M&A Stories

February 12, 2025

In private company M&A, buyers frequently make post-closing claims for a seller’s breach of the purchase agreement or for indemnification related to the seller’s pre-closing operations. The agreements typically define how long a buyer has to bring such claims—these are known as survival provisions.

While the survival period’s length is usually clear, disputes often arise over when it starts. This Delaware case highlights how survival periods for indemnification claims can extend well beyond closing.

The dispute involved a buyer who settled with a major material handling system customer of the seller over design and procurement issues. The seller argued in its motion to dismiss that the buyer’s claim was untimely because it was filed after the survival period had expired. Under the agreement, the survival period for breaches of representations and warranties—such as compliance with customer contracts and the absence of material defaults—began at closing and expired before the buyer filed its claim.

However, the court found that the seller had also agreed to indemnify the buyer for third-party losses arising from breaches of contract. The survival period for this indemnification claim did not begin at closing but instead when the buyer settled with the customer. As a result, the buyer’s claim was timely.

This case underscores a key distinction in Delaware law: First-party indemnification claims—where the buyer seeks recovery for the seller’s breach of representations, warranties, or covenants—typically accrue at closing. In contrast, third-party indemnification claims—where the buyer seeks recovery for losses related to external claims—accrue when the claim is resolved, such as through settlement or a final judgment. Sellers should be aware that survival periods don’t always begin running at closing, particularly when indemnification provisions extend to third-party claims.

Comment: Buyers and sellers can extend Delaware’s breach of contract statute of limitations by contract in most M&A transactions (purchase price at least $100K, 10 Del. C. § 8106).

See: In Re Takraf USA, Inc. v. FMC Technologies, Inc. C.A. No. N24C-01-090 VLM CCLD., Superior Court of Delaware, (January 30, 2025).

Thank you for reading this blog. If you have any questions, insights, or if you’d like to engage in a more detailed discussion on this matter, I invite you to reach out directly.

Feel free to send me an email. I value thoughtful discussions and am always open to connecting with business owners, management, as well as professionals who share an interest in the complexities of M&A law.

By John McCauley: I write about recenegal problems of buyers and sellers of small businesses.

Email: jmccauley@mk-law.com

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

Telephone:      714 273-6291

Podcasts https://www.buzzsprout.com/2142689/12339043

Check out my books: Buying Assets of a Small Business: Problems Taken From Recent Legal Battles and Selling Assets of a Small Business: Problems Taken From Recent Legal Battles

Legal Disclaimer

The blogs on this website are provided as a resource for general information for the public. The information on these web pages is not intended to serve as legal advice or as a guarantee, warranty or prediction regarding the outcome of any particular legal matter. The information on these web pages is subject to change at any time and may be incomplete and/or may contain errors. You should not rely on these pages without first consulting a qualified attorney.

Posted in indemnification, survival period commencement, third party Tagged with: , , , , , , , , , , , , , , , ,

Earnouts and the Importance of Key Employee Retention

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M&A earnouts pose significant risks for sellers, especially when buyers control post-closing business performance. This blog examines a case where a seller lost a $5 million earnout after a private equity buyer moved key employees to a separate management company. The Delaware court’s refusal to dismiss the seller’s breach of contract claims underscores the importance of structuring enforceable earnout provisions. Learn how sellers can protect their interests by securing key employee retention clauses and ensuring buyers adhere to their obligations.

M&A Stories

February 7, 2025

M&A earnouts are inherently risky for sellers because the buyer controls the post-closing performance of the business. One way to mitigate this risk is to require the buyer to retain key employees during the earnout period.

A Phoenix-based distributor of pipes, valves, and fittings faced this challenge after its 2022 sale to a Dallas-based private equity firm. The PE firm acquired the business as part of a roll-up, purchasing five other similar suppliers. To structure the transaction, it formed an acquisition subsidiary (the buyer) and a management company to oversee the six acquired businesses.

The seller was promised an earnout of up to $5 million based on a 2023 EBITDA target. The purchase agreement required the buyer to retain three named key employees during 2023. However, instead of keeping them within the acquired business, the buyer transferred them to the management company. As a result, the EBITDA target was not met, and the seller received no earnout.

In response, the seller sued the buyer and the management company in Delaware Superior Court for breach of contract. The buyer moved to dismiss the claim, but the court refused, allowing the seller to pursue its breach of contract claims.

The buyer’s reasoning for transferring the key employees remains unclear. It may have overlooked the contractual obligation or assumed the move wouldn’t affect the target’s financial performance. Regardless, the case highlights a critical lesson for both parties: buyers must understand and adhere to their earnout obligations, while sellers should ensure that key employee retention clauses are enforceable and protected against post-closing maneuvering.

See: In Re MHC IV, LLC v. TCFIV Venturi Buyer P, LLC. C.A. No. N24C-02-174 VLM CCLD., Superior Court of Delaware, (December 19, 2024).

Thank you for reading this blog. If you have any questions, insights, or if you’d like to engage in a more detailed discussion on this matter, I invite you to reach out directly.

Feel free to send me an email. I value thoughtful discussions and am always open to connecting with business owners, management, as well as professionals who share an interest in the complexities of M&A law.

By John McCauley: I write about recenegal problems of buyers and sellers of small businesses.

Email: jmccauley@mk-law.com

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

Telephone:      714 273-6291

Podcasts https://www.buzzsprout.com/2142689/12339043

Check out my books: Buying Assets of a Small Business: Problems Taken From Recent Legal Battles and Selling Assets of a Small Business: Problems Taken From Recent Legal Battles

Legal Disclaimer

The blogs on this website are provided as a resource for general information for the public. The information on these web pages is not intended to serve as legal advice or as a guarantee, warranty or prediction regarding the outcome of any particular legal matter. The information on these web pages is subject to change at any time and may be incomplete and/or may contain errors. You should not rely on these pages without first consulting a qualified attorney.

Posted in Key Employee Retention Requirement, problems with earnouts Tagged with: , , , , , , , , , , , , , , , , , , ,

Undisclosed Founder Loan Leads to Post-Merger Liability

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Undisclosed shareholder loans can become post-merger liabilities, creating unexpected financial exposure for buyers. This blog explores a real M&A case where a founder’s unrecorded loan led to legal disputes after a merger. Learn how courts interpret implied repayment obligations, why proper loan documentation is critical, and how deal structure—merger vs. asset sale—affects liability risks. Essential insights for business owners, buyers, and M&A professionals navigating legal complexities in private company acquisitions.

M&A Stories

February 6, 2025

Shareholder loans to a startup M&A target are sometimes not documented on the company’s balance sheet. This can cause problems for both the buyer and the lending founder.

This case involves the acquisition of a target company by merger. The buyer formed a subsidiary that merged into the target, making the target the surviving entity and a subsidiary of the buyer.

After the merger, the principal target founder sued the target in a Manhattan federal district court for repayment of a $1.5 million loan she had made to the company at its inception. The loan was not recorded on the balance sheet, catching the buyer by surprise. The target, now owned by the buyer, denied any liability, arguing that there was no loan documentation between the target and the founder. However, the court found extensive circumstantial evidence—such as the co-owner and the target bookkeeper providing information to the lender post-loan—that created an implied obligation for the target to repay the loan.

The clear takeaway for business owners is to document any loans they make to their company and ensure repayment terms are addressed in the acquisition documents. For buyers, structuring a deal as a merger is effectively like buying the stock of a company—all liabilities, including undisclosed ones, remain with the acquired business. One advantage of an asset sale is that a buyer can generally pick and choose which liabilities it will assume.

See: Alsayer v. Omnix Labs, Inc. No. 22-cv-2628 (LJL), United States District Court, S.D. New York, (January 15, 2025).

Thank you for reading this blog. If you have any questions, insights, or if you’d like to engage in a more detailed discussion on this matter, I invite you to reach out directly.

Feel free to send me an email. I value thoughtful discussions and am always open to connecting with business owners, management, as well as professionals who share an interest in the complexities of M&A law.

By John McCauley: I write about recenegal problems of buyers and sellers of small businesses.

Email: jmccauley@mk-law.com

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

Telephone:      714 273-6291

Podcasts https://www.buzzsprout.com/2142689/12339043

Check out my books: Buying Assets of a Small Business: Problems Taken From Recent Legal Battles and Selling Assets of a Small Business: Problems Taken From Recent Legal Battles

Legal Disclaimer

The blogs on this website are provided as a resource for general information for the public. The information on these web pages is not intended to serve as legal advice or as a guarantee, warranty or prediction regarding the outcome of any particular legal matter. The information on these web pages is subject to change at any time and may be incomplete and/or may contain errors. You should not rely on these pages without first consulting a qualified attorney.

Posted in Problems with Undisclosed Liabilities Tagged with: , , , , , , , , , , , , , , , , , , ,

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