Earnout Decision Provides Drafting Lessons for Acceleration of Payment and Good Faith Negotiation Provisions—Beckett

In Medal v. Beckett Collectibles (Aug. 22, 2024), the Delaware Court of Chancery, at the pleading stage of litigation, declined to dismiss claims that Beckett Collectibles, LLC, by failing to make certain earnout payments, breached the Stock Purchase Agreement pursuant to which it had acquired Due Dilly Trilly, Inc. ("DDT"). While the decision focused on a number of procedural issues, the court's brief discussion of the substantive earnout claims provides guidance for avoiding ambiguity in provisions relating to (i) the acceleration of earnout payments under specified circumstances and (ii) a requirement that the parties negotiate in good faith to resolve earnout disputes before bringing litigation.

Key Points

• Acceleration of payments. Language providing for payment of "unpaid" earnout amounts under specified circumstances should be clear as to whether the provision calls for acceleration of all of the unpaid earnout payments or just for payment of earnout payments earned but not yet paid. (See "Practice Points" below.)
  
  
• Good faith negotiations to resolve disputes. Language requiring the parties to negotiate or cooperate in good faith to seek to resolve any disputes before bringing litigation may not be enforceable if there is insufficient detail as to how the parties can fulfill the obligation and/or there are indications that the negotiations would be futile. (See "Practice Points" below.)

Background. In August 2022, Beckett (which specialized in pricing collectibles, such as trading cards and sports memorabilia) entered into a Stock Purchase Agreement to acquire all of the outstanding shares of DDT (which provided "digital market place intelligence" for the collectibles industry). The SPA called for a purchase price of $6 million to be paid at closing; and eight Milestone Payments, totaling up to $5.625 million, to be paid post-closing, contingent on the successful achievement of certain Milestones specified in the SPA. In connection with the SPA, DDT's founder, Andrew Medal, signed an Employment Agreement with Beckett, which called for Medal to serve as Beckett's Chief Innovation Officer for two years. The SPA designated Medal as the representative for the selling stockholders. Medal brought suit when Beckett did not pay milestone payments that Medal believed were owing. Judge Vivian L. Medinilla (sitting as a Vice Chancellor by designation), at the pleading stage of litigation, rejected Beckett's motion to dismiss the suit.

Discussion

The parties disputed whether language requiring the payment of all "unpaid Milestone Payments" under specified circumstances provided for acceleration of all of the earnout payments. Section 2.05(b) of the SPA provided that, if, during the Milestone Period, (i) Beckett terminated Medal's employment without Cause (as defined in Medal's Employment Agreement), or (ii) Beckett determined not to continue pursuing the development of the intellectual property and technology contemplated by the Milestones, then "[Beckett] shall pay to the Stakeholders the full amount of any unpaid Milestone Payments in accordance with Section 2.05(d)." The Plaintiff asserted that (i) had occurred, as Beckett terminated Medal's employment on August 15, 2023. The Plaintiff contended that, since Beckett did not provide any notice of any material nonperformance or other deficiency by Medal, and provided no viable Cause for termination even after pressed twice by Medal's counsel for an explanation for the termination, the termination was without Cause. The Plaintiff contended that (ii) also had occurred, as, between the filing of the Plaintiff's initial Complaint and Amended Complaint, Beckett terminated eight "key" DDT employees, telling them that Beckett was "going in another direction." The Plaintiff asserted that these terminations and Beckett's comment meant that Beckett had ceased pursuit of the Milestones.

The parties disputed the meaning of the language that Beckett "shall pay to Stakeholders the full amount of any unpaid Milestone Payments in accordance with Section 2.05(d)." The Plaintiff interpreted this language as meaning that, upon the occurrence of the enumerated events, all unpaid Milestone Payments would be accelerated and become due. Beckett interpreted this language as not providing for an acceleration of payments, but "only clarif[ying] that Milestones could continue to be earned after one of the three enumerated circumstances" and would then be payable under the mechanics set forth in Section 2.05(d), which expressly set forth the payment mechanics for "[a]ny Milestone Payment that is earned" (emphasis added). The court found the Plaintiff's interpretation reasonable-i.e., "that the parties intended Section 2.05(b) to reference Section 2.05(d)'s payment mechanics without embracing a requirement that the Milestone Payments be 'earned' by achieving said Milestones…." The court stated that, at the pleading stage, it need not consider whether Beckett's interpretation was reasonable, given that it found the Plaintiff's interpretation conceivably was reasonable. In other words, because Beckett's interpretation was not the only possible reasonable interpretation, the claim could not be dismissed at the pleading stage.

The parties disputed whether the Plaintiff was entitled to bring this litigation because the parties had not first negotiated in good faith to resolve their dispute. Section 2.05(f) of the SPA provided that, if the parties disagreed whether a Milestone had been achieved, before either could bring legal action, they had to have cooperated in good faith for 30 days to attempt to resolve their disagreement. The parties acknowledged that they had not engaged in negotiations to try to resolve their dispute. The court held that Section 2.05(f) was "not dispositive" and the Plaintiff could bring the suit. The court cited Anvil v. Iron (2013), where, under similar circumstances, the court had declined to dismiss a suit due to "a lack of detail as to which party was expected to commence negotiations, the essence of those negotiations, as well as indicia that the negotiations would be futile." In Beckett, the court stated that, similarly: "SPA Section 2.05(f) placed a mutual obligation on Plaintiff and Defendant to 'cooperate in good faith.' But the SPA contain[ed] no explanation of what the parties had to do to fulfill that obligation."

Further, the court stated, there were indications that such negotiations would have been futile as, allegedly, Beckett had rejected deliverables supporting the Milestones, without providing the written explanation for the rejections required by the SPA; the "rejection of the Milestone deliverables was predetermined"; and Beckett had not responded reasonably to two written requests from Medal's counsel seeking to ascertain the purported cause for termination of his employment. These "suggest[ed] negotiations would have been futile," the court stated. The court noted also that the Plaintiff filed its Complaint more than 30 days after the counsel's first letter was sent.

Practice Points

• Language calling for payment of all unpaid earnout amounts under specified circumstances must state clearly whether acceleration of all of the earnout payments is intended-or, alternatively, whether only payment of already earned but unpaid amounts is intended. Where a provision (Section X) sets forth the mechanics for payment of earned amounts, and another section provides for payment under specified circumstances of amounts "pursuant to Section X," the language should clarify whether the reference is only to the mechanics for payment set forth in Section X or also to the substantive provisions of Section X (such as its being applicable only to earned payments). Drafters should consider providing general statements of the parties' intentions and/or illustrative examples to further clarify the language.

• The parties should consider carefully whether termination of employment of a rollover employee (such as a founder) should trigger acceleration of earnout payments. It is one thing for a buyer to agree to pay out an employment agreement if the buyer decides to terminate the employee without cause. Tying the termination to acceleration of earnout payments is, generally, a much more significant (i.e., expensive) thing, however. Where an employee is going to be critical to achieving the earnout, there is a rationale for tying a termination of employment to acceleration of the earnout. A buyer's view of whether the employee is critical to achieving the earnout may change over time, however. The buyer may not want termination of employment to trigger acceleration, or may want termination of employment to trigger acceleration only if it is established that the termination was related to the earnout not being achieved.

• Drafters should provide some detail with respect to any requirement for good faith negotiations before bringing litigation. Consideration should be given to delineating the process for such negotiations, covering at least who is expected to commence negotiations and "the essence of th[e] negotiations." Drafters may wish to specify that the negotiation process will not be a prerequisite to bringing litigation if a party reasonably believes that the negotiations would be futile; or, alternatively, to specify that the negotiation process will be a perquisite to bringing litigation even if a party reasonably believes that the negotiations would be futile.

• Other recent earnout decisions and the court's trend. WT Representative v. Philips Holdings, a decision issued just a few days before Beckett, like Beckett,underscores that, when the court deems earnout provisions to be ambiguous, breach of contract claims for failure to pay the earnout generally will survive the pleading stage (unless the defendant's interpretation of the provisions is the only possible reasonable interpretation). Put differently, if the plaintiff has offered any reasonable interpretation (even if not the better interpretation), in most cases the claim will not be dismissed at the pleading stage. We note that while historically the court most frequently ruled in favor of seller-plaintiffs at the pleading stage of litigation over earnouts, more recently, in several cases (albeit not Beckett or Philips), the court has held in favor of buyer-defendants at the pleading stage. Nonetheless, with the court's focus generally being on the specific language of the parties' agreement as well as the overall factual context, the judicial outcome of an earnout dispute usually is highly uncertain.

• For additional practice points on earnouts, see our previous Briefings, including:

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