There's an old saying, probably at some point attributed to Abraham Lincoln or Einstein, that a bridge shows no allegiance to either side. It's a wonderful metaphor and one that dealmakers would be wise to remember when working to construct agreements to solve for divergent views on value. What two parties may have initially viewed as a solid foundation, may fail when tested, plunging those parties into the churning waters of judicial scrutiny.
Often discussed in the context of bridging a valuation gap, an "earn-out" can be a (seemingly) attractive solution for parties who have reached agreement on everything but the purchase price. Earn-outs can take many different shapes, but the basic concept involves a seller receiving a promise of additional consideration from buyer in the future if certain agreed upon milestones are achieved. Call it a compromise, call it delayed gratification, but do not call it simple: earn-out payments often give rise to disputes because the interpretation of what qualifies as the achievement of previously negotiated milestones can differ wildly once viewed through the muddied lens of time. With each party economically incentivized post-closing to adopt a reading that exploits any ambiguity to its benefit, and no reliable narrator to remind the parties of their prior positions, many bridges are burnt.
Typically, when a contract's provisions are unambiguous, a court will enforce the contract as written. Ambiguity arises when consideration of the context and plain meaning of the provision leads to two or more reasonable interpretations. When ambiguity exists, the courts will look outside the four corners of the contract to determine the parties' intent. Two recent Delaware decisions illustrate in different fashion how ambiguity can arise in the context of crafting an earn-out provision.
In Western Standard, LLC, v. SourceHOV Holdings, Inc., a buyer agreed to pay the sellers a $0.45 per share earn-out if a "Realization Event" occurred within seven years of closing. During that seven-year period, the buyer undertook several merger transactions, which resulted in a demand from the sellers to receive an earn-out payment, as they interpreted the series of mergers to fall within the scope of the definition of a Realization Event. The buyer resisted, maintaining that the contract plainly stated that mergers of the type undertaken by the buyer would not be considered a Realization Event. Vice Chancellor Joseph Slights lamented that, despite having read the earn-out provisions "many times," even he could not understand them "at all, much less attach definitive meaning to them." Because the vice chancellor found the contract to be unclear about what qualified as a Realization Event, the court entered a motion to dismiss in favor of the seller to permit the court to receive additional evidence of what type of events the parties intended to trigger the earn-out.
In Windy City Investments Holdings, LLC v. Teachers Insurance and Annuity Association of America (TIIA), TIAA acquired Nuveen, a mutual fund and advisory firm, from Windy City for $6.25 billion dollars, plus an earn-out based on Nuveen's future profitability. Unlike the earn-out provisions in Western that were based on an ambiguously-drafted milestone, the payment of Nuveen's earn-out was based on the achievement of certain specific financial metrics. However, the earn-out amount was subject to increase or decrease based on Nuveen's post-closing financial performance. Upon the achievement of the earn-out event, neither party could agree on the exact earn-out amount based on the definitions used in the contract. Here, the court found that "[n]either party provide[d] the only reasonable interpretation" of the earn-out calculation and rejected TIAA's motion to dismiss. Like Western, the court held that adequate evidence of each party's intent would have to be received before reaching a conclusion as to the earn-out amount.
Earn-outs can be a powerful tool to bridge the gap when parties
cannot meet in the middle, but that bridge can quickly collapse
under the weight of competing interpretations. As such, the
best way to bridge the gap on value may just be to agree on value
in the first place.
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