Comet Systems, Inc. v. MIVA, Inc.; Are Change-of-Control Bonuses Properly Deductible in Calculating Earnout Payments?

Comet was merged into a subsidiary of MIVA. The merger consideration consisted, in part, of a potential $10 million earnout, which could be earned over 2004 and 2005. The earnout was based upon Comet’s performance relative to three performance goals. One of the goals was a function in part of cost, defined in the merger agreement as “Operating Costs Excluding Amortization and One-time, Non-recurring Expenses.”

In anticipation of a potential transaction, Comet had adopted a bonus plan providing for the award of bonuses solely in the event of an acquisition or similar transaction. Under the plan, Comet paid out bonuses in connection with the MIVA merger, from the merger proceeds. MIVA deducted the payments as a cost in calculating the earnout, resulting in a reduced earnout payment.

A. The Bonuses Were Not A Proper Deduction

Vice Chancellor Lamb, in his opinion of October 22, 2008 (2008 WL 4661829), had little difficulty siding with the former stockholders of Comet in concluding that the “cost” of the merger bonuses was not an “operating cost” as defined in the merger agreement.

Delaware follows the “objective” theory of contracts whereby a contract’s construction should be that which would be understood by an objective, reasonable third party. The contract terms themselves are controlling when they establish the parties’ common meaning so that a reasonable person in the position of either party would have no expectation inconsistent with the contract language. Slip Opinion at 10-11, quoting Eagle Industries, Inc. v. DeVilbiss Healthcare, Inc., 702 A.2d 1228, 1232 (Del. 1997). MIVA argued that the merger bonuses qualified as an “ordinary” cost of doing business because they contribute to employee retention during a sales process. Responded Vice Chancellor Lamb:

“But the fact than an expense qualifies as an ordinary cost of business does not preclude treatment of that expense as one-time and non-recurring. Black’s Law Dictionary defines a ‘one-time charge’ as ‘[a]n ordinary cost of business excluded from income calculations.’ Thus, simply qualifying a cost as ordinary is not sufficient to dispositively determine that the cost is not one-time and non-recurring.”

Slip Opinion at 11.

The Vice Chancellor’s explanation of earnouts is instructive:

“Earnouts are typically used where the buyer and seller cannot agree on a price because the seller is more optimistic about the future prospects of a business than is the buyer. As a result, charges and costs which occur as a result of the merger and are not expected to be representative of future costs in the business are reasonably excluded. The natural reading ‘one-time, non-recurring expenses’ is to exclude exactly such charges.”

Slip Opinion at 11-12 (footnotes omitted).

B. Time For Performance

MIVA delayed an earnout payment it calculated was due, from March 2005 until June 2006. It argued that because there was no time specified for payment of any earnout amount in the merger agreement, the Court should not award interest on the amount due to the delay in its payment.

A specific payment covenant was not necessary, ruled the Vice Chancellor, because in every contract there is implied a promise or duty to perform with reasonable expediency the thing agreed to be done, and a failure to do so is a breach of contract. Slip Opinion at 18, citing Williston On Contracts. Therefore, MIVA had a duty to make the earnout payment within a “reasonable” time in the absence of a contractual term to the contrary. MIVA therefore should have made the payment within 90 days of its determination, and accordingly the plaintiff stockholders were entitled to interest on the overdue payment, notwithstanding the silence of the merger agreement on the time for payment.