When Dematic Corp. acquired Reddwerks Corp., it agreed to pay the selling shareholders an earnout fee over 14 months based in part on the amount of Reddwerks’ products that it sold.
After Dematic calculated it owed $1.5 million after the term ended, the selling shareholders sued, saying they were owed more. A court agreed, saying Dematic had incorporated Reddwerks’ computer code into its own products, and the sale of those products should have been factored into the earnout calculation. Dematic was on the hook for an additional $8.5 million.
“An earnout can bridge the valuation gap between buyer and seller and help get the deal done [but] taking this route is not without risk,” say Samantha Horn and Andrew Cunningham of Stikeman Elliott in an analysis. The attorneys are based in Toronto but track U.S. law on earnouts as part of their practice.
The problem Dematic faced is in the definition of company products. The merger agreement used non-technical shorthand that consisted mainly of one- and two-word descriptions that, as the court wrote, were “susceptible of different interpretations.”
To resolve the ambiguity, the court looked at evidence extrinsic to the agreement and found that the parties understood that the essence of Reddwerks’ business was the production of modules — blocks of code that execute specific functions within software, Horn and Cunningham say.
Based on that understanding, when Dematic used Reddwerks’ source code to enhance its own software, it was essentially adding Reddwerks’ products to its own products.
“The court reasoned that, because those functionalities that [Reddwerks] sold ‘were entirely a function of its source code’ … the best interpretation of ‘Company Products’ encompassed [Reddwerks’] source code,” the attorneys say.
As a result, the part of the earnout agreement that was tied to a formula had to be recalculated, increasing the amount to the selling shareholders to the agreed-to maximum of $10 million.
Other earnout cases Horn and Cunningham analyzed make clear in a similar way the importance of using precise language in the contract terms.
In one case, Retail Pipeline sued its buyer, Blue Yonder, for not making a good faith effort to conduct its business in a way that maximized the earnout potential they had agreed to.
In their negotiations prior to the acquisition, the companies talked about the buyer developing a product, called “Flowcaster 2.0,” or something similar, that would generate IP licensing income that would go into the calculation of the seller’s earnout. Blue Yonder never developed the product, and instead of paying an earnout of up to $7 million based on the top end of the formula they agreed to, it paid less than $1 million.
The court ruled in a summary judgment, and an appeals court agreed, that there was no breach of good faith because the discussion of developing the Flowcaster 2.0, or other product, was never formalized in the contract even though the seller had asked for it to be included.
“As far as the Court was concerned … Purchaser had simply chosen to focus its business activities in areas that happened not to enhance Seller’s earnout,” the attorneys say in their analysis. “There was no evidence that this action had been taken to undermine the earnout payment.”
In another case, the selling shareholders accused the buyer of breach of contract because it failed to pay an earnout amount based on the return of a key customer. The selling shareholders said the conditions were met for them to receive the top end of the earnout agreement — $6 million — because not only did the key customer return, it agreed not to exercise its early termination right for a year, both conditions included in the earnout agreement.
But the court sided with the buyer, saying the conditions weren’t met. Based on the contract language, the key customer had to enter into a new or amended existing agreement without a right to early termination. Or it had to enter into a new agreement that was otherwise satisfactory to the buyer.
The court ruled the agreement wasn’t new. Rather, it was the existing agreement with additional provisions added on. And it still contained the right to early termination; the key customer had only agreed to a one-year suspension of that right.
“Selling Shareholders argued that [the suspension] ‘entirely supplants’ the old one,” the attorneys say in their analysis, but “the Court held that the new provision ‘unambiguously supplements, rather than supplants’ the old provision.”
Bottom line for in-house counsel: Choose your words carefully. “Circumstances [can] arise that aren’t clearly covered by the earnout language,” the attorneys say.
Today’s General Counsel also reported on the analysis by Horn and Cunningham.