Explore a real M&A case where an earnout agreement led to a legal dispute. Learn how buyer-seller dynamics and the duty of good faith played a crucial role in the court’s decision.
M&A Stories
March 19, 2019
Introduction:
When buyers and sellers can’t see eye to eye on a purchase price in M&A deals, they often turn to earnouts as a solution. An earnout divides the purchase price into two parts: a fixed amount and a contingent sum based on the business’s post-closing performance. In this case, we delve into a dispute that arose from such an earnout arrangement.
The Deal:
In 2013, a business providing pharmaceutical products and services to long-term care facilities in New Mexico saw a buyer and seller agreeing to an asset purchase agreement with an earnout provision. This earnout was tied to the gross profits generated during the period between the first and second anniversary of the closing.
The earnout would amount to $1.25 million if the gross profits from customers who remained with the buyer through the second anniversary reached at least $2.2 million. A formula would reduce the earnout for gross profits between $2.2 million and $1.87 million, and no earnout would be paid if gross profits fell below $1.87 million.
The Lawsuit:
At the end of the second anniversary of the closing, the buyer informed the seller that the business had missed the minimum gross profit target by $649K, resulting in no earnout. The seller responded by suing the buyer, alleging that the buyer had intentionally mismanaged customer accounts, leading clients to terminate their contracts before the two-year mark, thus depriving the seller of their earnout.
The seller argued that the buyer violated an implied duty of good faith and fair dealing under Delaware law by mishandling the accounts acquired from the seller, which reduced the chances of the earnout being realized.
The buyer sought to dismiss the lawsuit with a summary judgment, contending that it made no economic sense to sabotage customer accounts just to avoid paying the seller. They claimed that the seller failed to present any facts to dispute the buyer’s good faith management of the accounts.
Court’s Decision:
The court decided to allow the lawsuit to proceed, finding that the seller had presented specific allegations of buyer misconduct sufficient to create a factual dispute over the buyer’s good faith. Notably, evidence from an employee of one of the seller’s largest customers was presented, highlighting problems with the buyer’s performance and leading to the customer’s contract termination.
Additionally, a pharmacy consultant who had worked with both the seller and the buyer testified to issues related to billing, medication delivery, pricing, and medical record-keeping during her time with the buyer.
Comment:
This case highlights the risks associated with earnout agreements, where sellers rely on buyers to meet performance targets. When disputes arise, as in this instance, they often lead to costly legal battles. It’s important to note that, ultimately, the court held after trial that the buyer did not act in bad faith.
Case Reference:
Huntingford v. Pharmacy Corporation Of America, No: 1:17-cv-1210-RB-LF, United States District Court, D. New Mexico, (March 1, 2019).
By John McCauley: I help businesses minimize risk when buying or selling a company.
Email: jmccauley@mk-law.com
Profile: http://www.martindale.com/John-B-McCauley/176725-lawyer.htm
Telephone: 714 273-6291
Check out my book: Buying Assets of a Small Business: Problems Taken From Recent Legal Battles
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