Earnouts in M&A: Delaware Court Rules Against Founder

In mergers and acquisitions (M&A) transactions, parties frequently use mechanisms to bridge valuation gaps. One of the most common is the earnout, a contractual provision that conditions payment of part of the purchase price on the acquired company meeting future financial targets. However, when the founder remains in management after the sale, this structure can create misaligned incentives.

A recent decision by the Delaware Court of Chancery in In re Saama Technologies Litigation illustrates the practical risks of this dynamic. The court determined that a private equity fund (the buyer) did not owe a US$ 67.5 million earnout payment to the founder and former CEO of the acquired company. Moreover, the court ordered the executive to pay US$ 7.3 million in damages to the company for breaching his fiduciary duty of loyalty.

The Transaction Context and the Earnout’s Origin

In the summer of 2021, the buyer approached the founder to acquire control of Saama Technologies. Negotiations initially centered on an enterprise value of US$ 505 million. During due diligence, the buyer identified accounting anomalies and reduced the valuation to US$ 435 million.

To bridge the valuation gap, the buyer proposed an earnout. The merger agreement provided that the buyer would acquire 62% of the company, a co-investor syndicate would hold 13%, and the selling shareholders, including the founder, would retain 25%. The earnout of up to US$ 67.5 million would be paid if, by the end of 2021, company revenue reached US$ 72 million and annual recurring revenue bookings for signed contracts reached US$ 27 million.

Conflict of Interest and Breach of Fiduciary Duty

The founder continued to serve as CEO during the earnout period. According to court records, he aggressively directed the company’s focus toward meeting the short-term targets required to secure the additional payout. At the end of 2021, the founder submitted a statement indicating that the targets had been met.

An accounting expert hired by the buyer reviewed the statement and challenged the revenue recognition practices. The buyer refused payment, contending that the founder’s actions prioritized short-term financial metrics to the detriment of the company’s long-term financial health and growth. The fiduciary duty of loyalty requires corporate officers to act in the company’s best interest, rather than for personal benefit.

The court agreed with the buyer. The decision emphasized that the executive’s actions crossed the line of permissible aggressive business strategy, amounting to bad faith driven by self-interest. Due to the post-closing deterioration of the business, the founder was terminated in June 2022 and subsequently ordered to indemnify the company for the resulting damages.

The Efficacy of Arbitration Clauses

The case also provides lessons regarding dispute resolution. The merger agreement established an expert arbitration procedure to resolve earnout disputes through an independent accountant. The founder initially sought judicial enforcement of the arbitration provision and prevailed. However, he subsequently changed strategy and amended his complaint to include breach of contract and fiduciary duty claims in court, seeking a declaratory judgment that the earnout was due.

Shifting the strategy toward traditional litigation backfired, resulting not only in the forfeiture of the earnout, but also in liability under the counterclaims asserted by the buyer.

Practical Lessons for M&A Transactions

The Delaware decision underscores the need for diligence when structuring and monitoring earnout provisions. Several practical measures can help mitigate similar risks:

• Active monitoring: The buyer should actively supervise the acquired business during the earnout period to ensure operations adhere to the standards and covenants set out in the agreement.
• Attention to anomalous results: If the target company abruptly exceeds performance expectations, buyers should examine sales processes to verify whether management is manipulating metrics.
• Contractual specificity: Earnout clauses should be detailed and well-defined. While Saama’s contract required good-faith operations, the parties would have benefited from explicit terms governing discounting, bundled or free services, the distinction between bookings and recognized revenue, and revenue allocation across multi-year subscriptions.

Although the buyer prevailed in the dispute, the outcome followed years of litigation and significant value destruction within the acquired company. Contractual precision and rigorous post-closing governance remain critical to preserving investment value.

This content is for informational purposes only and does not constitute legal advice. For guidance on specific matters, consult a qualified lawyer.