Mergers & Acquisitions 2022 Annual Review

18 MORRISON FOERSTER Interest in earnouts should continue in the face of 2023’s uncertainties. At the beginning of the pandemic, earnouts grew in popularity in private M&A as a method to bridge valuation gaps and mitigate integration risk in an uncertain economic environment. Early-stage or pre-revenue start-up targets or targets that relied heavily on R&D were particularly impacted by this trend. However, the use of earnouts subsided in 2021 and early 2022 as parties grew accustomed to the issues created by the pandemic. Notwithstanding the recent decline, anticipated economic headwinds in 2023 suggest that earnouts may play a material role in private M&A transactions, particularly in transactions involving early-stage targets. Revenue and non-financial metrics have become the most common earnout metrics. Revenue-based metrics have emerged as the overall most- favored earnout benchmark, though the appropriate metric for any particular deal ultimately is driven by the applicable industry, individual company characteristics, and the goals of the parties. In early 2021 and 2020, 41% of earnouts utilized a revenue metric, and only 11% of transactions used an earnings or EBITDA calculation. 15 A trend that has continued, particularly for life sciences companies, is the use of non-financial metrics, which tend to be tied to completion of identified projects or more specific development or approval milestones. Trade-offs in post-closing covenants. Transactions containing an affirmative covenant by the buyer to run the business “consistent with past practice” rose early in the pandemic (to about 21% of 2020–1Q2021 deals), although the majority (79% in 2020–2021) did not include this covenant at all. Conversely, the use of covenants obligating the buyer to run the acquired company in a manner that would maximize the earnout fell. Delaware courts read earnout provisions closely. In one recent case, the Delaware Court of Chancery emphasized its reluctance to infer contractual provisions outside of the express language in the agreement. In that case, the court rejected claims of an implied covenant of good faith and fair dealing, which the seller alleged would have obligated the acquiror to act to achieve the earnout milestones, and declined to “rewrite” the agreement to imply provisions that the seller failed to negotiate. 16 In another recent case, as noted above, the court found no difference between “commercially best efforts” and “best efforts,” in supporting its determination that an acquiror was entitled to stop making earnout payments. 17 One takeaway from both cases is that earnout provisions must be drafted carefully to ensure that future interpretation of the provision will be consistent with the parties’ intent at the time of drafting and to reduce the likelihood of a distracting and expensive post-closing dispute. 7. POTENTIAL USE OF EARNOUTS Notwithstanding the recent decline, anticipated economic headwinds in 2023 suggest that earnouts will continue to play a material role in private M&A transactions.