The basic point of an earnout is to protect a buyer from the risk of overpaying for a business. By conditioning payment of at least some part of the purchase price on the success of the underlying business, the buyer is in effect saying "show me the money." So it would seem inconceivable that if the acquired business is a failure -- that is, not only underperforms, but actually goes bust -- a buyer using an earnout could end up owing additional money to the seller. Yet this is exactly what happened in a case recently decided by the 1st U.S. Circuit Court.

The case­ -- Sonoran Scanners Inc. v. PerkinElmer Inc. -- is more than just a curiosity. Earnouts, which have always been a useful tool to bridge a pricing gap between a buyer and seller, have grown quite popular recently. Why? All the normal difficulties associated with valuing a business become that much harder in an economic downturn. Sellers don't want to sell at the bottom. Buyers don't want to pay based on historical results that may not be repeated or based on projected improvement that are at odds with an economy that seems stuck in neutral. Earnouts represent a particularly convenient way for parties to share valuation risk when times are uncertain.

Sometimes expedience comes at a price, however. The Sonoran case involved the 2001 acquisition by PerkinElmer Inc., a public company, of computer plate printing business Sonoran Scanners Inc. While the decision is limited to Massachusetts law, the basic principles of the case are widely applicable, and in fact, similar decisions have been handed down in M&A-intensive jurisdictions such as New York, Delaware and California. The case is a shot across the bow to deal professionals looking at earnouts as a convenient means of side-stepping difficult issues and smoothing the way to a closing.

The background of the 2001 transaction, which follows a familiar pattern, is important to understanding the decision. The Sonoran business was founded by an entrepreneur in 1997 to develop and sell a high-speed digital-printing technology to the newspaper business. While the products generated interest, customers were reluctant to do business with a startup company, and Sonoran was never able to sell a single unit. Facing liquidity problems, the founder sold the business to PerkinElmer.

The terms of the transaction included a $3.5 million closing payment to Sonoran. In addition, the purchase agreement contained an earnout provision that permitted Sonoran to receive up to an additional $3.5 million over five years if sales of Sonoran products met designated targets. PerkinElmer hired the founder as general manager of the business under an employment agreement that likewise provided the founder could receive bonuses of up to $6.6 million over five years if the Sonoran business met certain sales thresholds.

Unfortunately, the business was a complete failure in PerkinElmer's hands. In the three years following closing, PerkinElmer sold only one unit and, accordingly, paid nothing under the purchase agreement earnout or employment agreement bonus provisions. In October 2004, PerkinElmer shut the business down and laid off the entire staff, including the founder.

The founder subsequently brought suit on a number of grounds, but most notably claiming that PerkinElmer had breached an "implied obligation to exert reasonable efforts to develop and promote Sonoran's products." Sonoran claimed this obligation was "implied" because the purchase agreement itself did not contain any provision obligating PerkinElmer to make such efforts. (The 1st Circuit acknowledged that PerkinElmer did nothing that constituted a breach of any express provision of its agreements with the seller.)

While it would be easy to see Sonoran's claim as a transparent attempt to retrade its initial bargain, the 1st Circuit took a different view, finding that PerkinElmer did have an obligation to use reasonable efforts to promote and sell the Sonoran products -- an obligation that was not written anywhere in the purchase agreement but rather should be "implied" by law.

The source of the court's logic was a series of cases dealing with exclusive licenses and, in particular, a 1942 Massachusetts Supreme Court case that found that "one who obtains the exclusive right to manufacture a product under a patent has an implied obligation to exert reasonable efforts to promote sales of the process and to establish, if reasonably possible, an extensive use of the invention." While PerkinElmer argued the 1942 case was limited to exclusive licenses, the 1st Circuit disagreed. Instead, the court found that a number of aspects of the transaction supported a conclusion that a reasonable efforts obligation was, if not stated, "implicit" in the transaction. These factors included the substantial size of the earnout payment in relation to the up-front payment, the fact that a significant portion of the up-front payment went to Sonoran's creditors and, most notably, that "there was no language in the agreement negating an obligation by PerkinElmer to use reasonable efforts or conferring absolute discretion on PerkinElmer as to the operation of the business."

Parties accustomed to negotiating earnouts are likely familiar with the court's reference to this missing language. Buyers often try to bargain for absolute discretion in operating the acquired business. With a stake in its success, sellers alternatively often demand some level of control, including the right to approve capital and operating budgets, changes in management or accounting methods, acquisitions, or other material events. The Sonoran case has changed the negotiating landscape. Apparently, it won't be enough for buyers to convince sellers to forgo control or management rights. To disclaim the implied Sonoran duties, buyers now will have to convince sellers to sign a contract stating the buyer does not have to even try to make the business a success.

The decision raises other questions for buyers of businesses. The seller's "reasonable efforts" claim applied both to the purchase agreement and the founder's employment agreement. The 1st Circuit's decision was based on the purchase agreement -- the court sidestepped the question of whether the employment agreement, which made the founder's bonus dependent upon product sales, also gave rise to an implied obligation on PerkinElmer's part to use reasonable efforts to sell the products. It apparently therefore remains an open question whether a commonplace incentive bonus arrangement can give rise to claims by the employee that the employer did not do enough to allow the employee to earn the bonus.

Note that PerkinElmer did have one fact working in its favor -- the earnout with Sonoran was capped at $3.5 million. In situations where the payout formula is a simple royalty percentage of revenue or cash flow (as has occurred in similar cases), the potential damages in these cases can be significant. More fundamentally, the case is a reminder that deal professionals often believe -- rationally but incorrectly -- that the bargain between two sophisticated parties is reflected solely in what their transaction documents say. Courts, alternatively, are under an ever-present temptation to redraw transactions viewed in hindsight as unfair, a temptation that takes form in amorphous legal doctrines such as the implied reasonable efforts duties found to apply in the Sonoran case.

But perhaps the biggest lesson of the Sonoran case is that transaction parties regularly view earnouts as an effective means of resolving differences in how the parties value the acquired business. There is no question that earnouts can smooth over differences and speed the way to a closing. The reality, however, is that earnouts often don't avoid arguments. They just postpone them.

David S. Denious, a partner at Dechert LLP, advises clients on leveraged acquisitions and dispositions and corporate finance transactions.