Yonder Window Breaks: Earnout Covenants in Acquisitions

Mergers & Acquisitions

Earnouts, which provide sellers payouts if certain post-closing milestones are reached, have become increasingly popular in recent M&A transactions given today’s uncertain regulatory and financial climate.  Inflation, supply chain failures, war, fuel shortages, COVID and other health crises have all contributed to deal uncertainty and the resulting increased use of earnouts.  However, a recent Second Circuit decision illustrates some of the pitfalls in drafting earnout provisions.  In Retail Pipeline, LLC v. Blue Yonder, Inc., the U.S. Court of Appeals for the Second Circuit held that a buyer did not breach an earnout provision by failing to develop a new product, even though the earnout was based in part on revenue from the new product.

The case stemmed from the acquisition by JDA Software (which would later be renamed Blue Yonder) of Retail Pipeline’s interest in certain intellectual property associated with “Flowcasting,” a software product used for supply chain management.  Flowcasting was developed by Retail Pipeline’s principals, Darryl Landvater and Andre Martin.  Under the parties’ Purchase Agreement executed on February 25, 2014, JDA agreed to make an upfront payment of $3 million and up to an additional $7 million in earnout payments based on revenue earned from the licensing of certain products through December 31, 2018, including “Flowcasting 2.0 or similar product.”  At the end of the earnout period, an earnout payment of less than $1 million became payable, and Retail Pipeline filed suit, claiming JDA breached its obligations under the Purchase Agreement in connection with the earnout.

Retail Pipeline advanced two arguments.  First, Retail Pipeline argued that JDA breached the Purchase Agreement by failing to develop and market a “Flowcasting 2.0 or similar product,” thus preventing any revenues from being earned on such a product, resulting in a lower earnout.  Retail Pipeline stated that JDA had agreed to develop this new product according to a “roadmap” email from a JDA employee, which itself was based on a meeting with Landvater and Martin.  However, the court held that JDA had not breached the Purchase Agreement because the agreement itself did not contain an explicit obligation on the part of JDA to develop such a product.  The fact that the earnout provision was tied to revenue for an as-yet-to-be-developed product was not sufficient to oblige JDA to develop and market such a product.

Second, Retail Pipeline argued that JDA breached an implied covenant of good faith and fair dealing by failing to allocate necessary resources for the development team to create “Flowcasting 2.0.”  Retail Pipeline further contended that JDA breached this implied covenant by first removing Landvater from his product management position at JDA and then by later firing him.  The court acknowledged that under Delaware law an implied covenant of good faith and fair dealing is inherent in all contracts but noted that a breach of this implied covenant requires an intentional act designed to deprive the other party of achieving an earnout.  The court gave as examples actively shifting costs into the earnout period without justification and redirecting sales to minimize resulting revenue.  However, in this case, the court found that JDA’s actions did not evidence an intent to deprive Retail Pipeline of the earnout proceeds but instead appeared validly intended to direct efforts to the acquired assets that were deemed most profitable.

The key takeaway from this case boils down to clear and complete drafting, recognizing that a Delaware court will not protect a right that a party failed to negotiate into a contract.  If a seller anticipating an earnout payment is counting on revenue from a new product to bolster the earnout, then the seller should insist on clear language obligating the buyer to create, develop, market, distribute and take all other actions to promote such product.  A seller might seek to include a requirement that the buyer use its best efforts to develop and monetize such a product.  Additionally, a seller may try to include language describing objectives, milestones, target dates, capital resources and key personnel related to the development and marketing of the applicable products.  Further, a seller might insist on certain employment agreements or other contractual obligations requiring the buyer to keep certain management or other key personnel throughout the earnout period.  On the other hand, a buyer that wants to retain flexibility with regard to running an acquired business during an earnout period may want to explicitly state that it is entitled to operate in its sole discretion, including decisions on developing and marketing any products tied to an earnout payment.  A buyer typically will seek to include language maximizing its discretion and leeway in hiring and terminating personnel and managing resources post-closing.

Sam C. Kennedy is an attorney in the M&A Practice Group of Wyrick Robbins Yates & Ponton LLP, which represents clients across a broad range of industries in connection with their significant corporate transactions.  The group publishes Practice Briefs periodically as a service to clients and friends.  The purpose of this Practice Brief is to provide general information, and it is not intended to provide, and should not be relied upon as, legal advice.