Judge Young Lays Down the Law on Earn-Outs

by Lee Gesmer on December 30, 2008

Judge Young Lays Down the Law on Earn-Outs

[Update: the decision discussed below was reversed by the First Circuit in October 2009.  Decision here]

So, you have a great little business, and a large company wants to acquire it. The buyer argues that payment for your company should be determined by an “earn-out” — the buyer’s sales of your product will determine the purchase price (in whole or in part) based on an agreed-upon formula. “Perfectly normal,” your lawyer assures you. “Seen it done in 8 acquisitions out of 10,” he says. You say nothing – your lawyer knows the ropes, right?

But, as Massachusetts federal district court Judge William Young made clear in his recent decision in Sonoran Scanners v. PerkinElmer, if you (the seller, in this case tiny Sonoran Scanners) expect the buyer (in this case the much larger PerkinElmer) to market your product (leading to sales and payments to you under the earn-out formula), you’d better make sure that the contract spells out the actions the buyer is expected to take to promote the product. Otherwise, you risk the fate that Sonoran Scanners experienced after it sold its business to PerkinElmer – PerkinElmer did little or nothing to promote the product properly during the five year earn-out period, sales were almost zilch, and in the end Sonoran Scanners was paid nothing.

It’s true that sometime you just gotta sell, and you have to take what you can get. That may have been the situation in this case – the decision doesn’t tell us. But if that’s not the case, it’s just not enough to assume that the buyer will promote your product, and if it doesn’t help much to argue breach based on “implied” contractual terms, breach of “good faith,” and other “soft” legal theories, as Sonoran Scanners did in this case. In all but the most extreme cases, “implied” will get you nowhere – if the judge doesn’t throw your claims out of court before trial (as Judge Young did to the plaintiff in this case), the jury almost certainly will. Why do you have to argue “implied” contract terms , most jurors will ask. If you were counting on the buyer of your company to make an effort to sell your product after the acquisition, why wasn’t it express?

Bottom line: avoid earn-outs when possible, but if you can’t make sure you have a good, strong contract, in black ink on white paper (preferably in a bold, large font), that nobody can misread, misinterpret or deny. That contract should state as precisely as possible what the buyer will do to promote and sell your product during the earn-out period. Most sellers know this, but sometimes the opportunity to sell a business for what the seller naively hopes will be a big payday if all goes well, when combined with the hard-nosed negotiating tactics of many buyers, can blind the seller to the risks of assuming the buyer will act in the seller’s best interests.

Judge Young’s decision in PerkinElmer is a good guide to the law in this area. As usual, Judge Young does a thorough job of analyzing the issues and educating businesspeople on what they can expect if they’re forced to go to court in this situation. In the end, Judge Young left Sonoran Scanners with a couple of minor claims, but 90 percent of Sonoran’s case was dismissed before trial on summary judgment. It would be surprising if the case doesn’t settle at this point, with PerkinElmer holding the stronger hand.

  • Link to the decision here

Previous post:

Next post: