Make Sure the Language in Your Earnout Provision Accounts for the Obstacles to Receiving Those Future Payments

In M&A transactions, the buyer and seller often disagree about the value of the business or asset being sold. A popular solution is an earnout clause that entitles either the seller or buyer to future payments from the business’s post-closing revenues, typically in exchange for accepting the purchase price that the other party prefers. When deployed properly, an earnout provision allows the buyer and seller to spread their respective risks to one another, employing creative contractual language that conditions future payments on the company reaching certain financial milestones. Since earnout clauses seek to minimize present-day risk through future, conditional events, counterparties to M&A transactions often struggle to fashion language that accomplishes that goal.

As Obsidian Fin. Group, LLC v. Identity Theft Guard Solutions, Inc., C.A. No. 2020-0485-JRS (Del. Ch. Apr. 22, 2021) teaches, a party’s failure to adequately consider and account for obstacles to future earnout payments may prove fatal to that party’s right to those payments. In that case, the Delaware Court of Chancery dismissed Obsidian Finance Group, LLC’s (“Obsidian”) breach-of-contract claim against Identity Theft Guard and Identity Experts Holdings, Inc. (collectively, “ID Experts”) after concluding that the conditions precedent to earnout payments had not been met. The issue largely boiled down to Obsidian’s failure to research and understand the regulations and statutes that precluded the triggering event from occurring.

Background

On September 1, 2015, ID Experts received a contract worth $133 million from the U.S. government to address certain cybersecurity incidents (the “OPM Contract”). The OPM Contract was subject to federal law requiring persons affected by data breaches to receive fraud protection services for at least ten years — thus increasing the likelihood that the OPM Contract might be extended. Not long after entering into the OPM Contract, ID Experts began a search for an acquiror for its business. ID Experts “touted the OPM Contract and incorporated that opportunity and the prospect of an extension into its valuation.”

In August 2016, Obsidian and ID Experts entered into a Merger Agreement, which attempted to price the contingent nature of the OPM Contract’s extension through an earnout clause providing that if ID Experts “enters into an extension or renewal of the OPM Contract for an additional term of at least six (6) years,” then Obsidian is entitled to 50% of $7,158,684 (the “Earnout Amount”).

On December 21, 2018, ID Experts entered into a second OPM Contract for an additional term of 4.5 years for the base and option period and a one-year transition period (the “Second OPM Contract”). On January 8, 2019, ID Experts notified Obsidian that since the Second OPM Contract was not a renewal of “at least six (6) years,” Obsidian was not entitled to the Earnout Amount. The reason was that Federal Acquisition Regulation (“FAR”) 17.204 (e), which existed at the time the Merger Agreement was negotiated and signed, precluded the OPM Contract from being renewed for longer than 5 years for the basic and option period.

Confronted with the fact that it conditioned future payments on an impossibility — the Second OPM Contract having a term of six years or more — Obsidian filed suit against ID Experts. Obsidian’s lawsuit asserted that: (1) ID Experts breached the Merger Agreement by failing to pay the Earnout Amount; (2) the conditions precedent to the payment of the Earnout Amount were met; and (3) the Merger Agreement should be reformed because it was based on a mistake of fact and law. ID Experts moved to dismiss these claims, and the Court of Chancery granted the motion, after rejecting each one of Obsidian’s arguments.

Analysis

The vice chancellor began his analysis of Count I by underscoring the parties’ agreement that the Second OPM Contract’s 5.5-year term did not meet the Merger Agreement’s precondition for payment of the Earnout Amount. Despite that reality, Obsidian argued that ID Experts was liable for breach because the limitations imposed by FAR made performance impracticable. That argument failed, however, because impracticability/impossibility is a defense to nonperformance and has never been used to attach liability to the defendant because the plaintiff failed to consider and address a risk. Indeed, “[t]here can be no invocation of impossibility [or impracticability] defense if the supervening events were reasonably foreseeable, and could and should have been anticipated by the parties … with the four corners of the agreement.” Since the relevant FAR regulations were public knowledge at the time of the Merger Agreement, Obsidian, as a sophisticated party with significant experience with government contracts, should have been aware of the law and could have negotiated an earnout provision consistent with FAR. Obsidian’s failure to adequately assess and address the risks to its future payments is no basis for attaching liability to ID Experts.

Obsidian next argued that the six-month difference between the length of the Second OPM Contract (5.5 years) and the six-year renewal term that would have triggered payment of the Earnout Amount was immaterial. Thus, ID Expert’s execution of the Second OPM Contract was ‘close enough’ to the precondition that its refusal to pay the Earnout Amount was a breach of contract. In assessing Obsidian’s assertion, the court noted that the “value of the contingent consideration is inextricably linked to the estimated probability of the contingent event’s occurrence,” and changing “the benchmark of the earnout would be to change its risk profile.” Since Delaware law prohibits a party from seeking through litigation contractual rights that it failed to obtain in negotiation, the court rejected Obsidian’s argument, finding that “[a]ny adjustment to the earnout condition … would be ‘material’ as a matter of law.”

Similarly, the vice chancellor declined to credit Obsidian’s demand for declaratory judgment that the conditions for payment of the Earnout Amount were satisfied as a result of multiple renewals of the OPM Contract. After underscoring that declaratory relief is available only where an “actual controversy exists,” this opinion notes that there is no conflict between the unambiguous terms of the Merger Agreement and the Second OPM Contract. The court then refused to create controversy by adopting implied language proposed by Obsidian, emphasizing that it “is not the proper role of a court to rewrite or supply omitted provisions to a written agreement.”

Finally, the court held that Obsidian was not entitled to reform the Merger Agreement, as a matter of law, because that remedy required Obsidian to plead particularized facts reflecting a mistake on which the Merger Agreement was based. Fatal to Count III was that Obsidian failed to describe its “specific prior understanding” regarding the terms it seeks to reform and how that understanding differs from the Merger Agreement.

Takeaway

If entering into a purchase and sale contract or merger agreement with an earnout provision, take time to ensure that the provision’s language adequately addresses the risks associated with deferring payment of some of the transaction value — including by ensuring that there are no regulations or laws prohibiting the triggering event for earnout payments.