Defining Earnout Cases Under Delaware Law

Samantha Horn and Andrew S. Cunningham, in their article on the Stikeman Elliott website, suggest that an earnout can be a useful tool to bridge the valuation gap between buyer and seller, especially when the future prospects of the acquired business are uncertain. However, there are certain risks associated with the earnout, particularly when there are unforeseen circumstances that are not clearly addressed in the earnout agreement. If the earnout period is long, there is a high likelihood that circumstances may change over time.

They discussed a sampling of Delaware cases where courts enforced the literal meaning of clearly worded earnout provisions.

In Fortis Partners v. Dematic, the earnout amount was tied to sales of the seller’s “company products,” a term so vaguely defined in the agreement that a review of the negotiations was required. Ultimately, the court accepted the seller’s view that “company products” included software developed after the merger that made use of the seller’s purchased source code.

Retail Pipeline v. Blue Yonder involved the sale of IP rights in supply chain software by the seller to the purchaser. The purchase agreement included an earnout clause tied to specific revenue streams, including licensing revenue from a product referred to as “Flowcasting 2.0 or similar product.” However, the agreement lacked detailed definitions or obligations related to its development.

The seller alleged a breach of contract, arguing that: The ambiguous description of the product should be clarified using extrinsic evidence (suggesting an obligation to develop the product), and a breach of the implied covenant of good faith and fair dealing because the purchaser’s failure to develop the product deprived them of the expected earnout.

The court rejected the breach of contract claim, stating that ambiguity in the product description couldn’t be used to introduce obligations outside the written agreement.

The implied covenant claim was also unsuccessful. The court said the purchaser isn’t required to run its business solely to maximize the seller’s earnout. This case highlights the importance of clear and explicit earnout provisions to avoid ambiguity and disputes in such agreements.