Goodwill Gone Bad: How Closing Conditions Can Protect a Buyer's Contractual Rights to a Seller's Key Employees
How much would you pay for a “fair chance” at offering employment to a competitor’s top salespeople? What if you had valued the goodwill associated with these key employees to be worth nearly $3 million dollars, but was told by a court that your failure to structure an asset purchase properly entitled you to only one dollar in damages? A recent case before Delaware’s Court of Chancery illustrates how disciplined deal management by a company’s executive officers and thoughtful planning by legal counsel are essential to securing a buyer’s rights to the intangible business asset of human capital.
When the CEO of Ivize LLC, strode into the former Milwaukee offices of one of his company’s chief rivals on July 27, 2007, he was stunned to find the office in disarray and the absence of the branch’s manager and two top sales associates. Just the previous day, he had closed an asset purchase deal in which his company bought the Kansas City and Milwaukee branches of Compex Litigation Services for $3.4 million. As an established, nationwide provider of litigation support services to law firms and other clients, Ivize placed little value in Compex’s proprietary software, business model, or trade secrets. Instead, its CEO was primarily interested in buying what he regarded as Compex’s most valuable asset: its customers.
Ivize accordingly allocated approximately $2.9 million of the purchase price for Compex’s two branches to goodwill associated with the transferred businesses. With respect to Compex’s Milwaukee office, the goodwill in concrete terms meant the customer relationships developed by its two top salespeople, who respectively accounted for 65% and 35% of the branch’s sales. Where, he wondered as he gazed around in disbelief at Compex’s largely abandoned offices, were the top salepeople?
Equally puzzling to the CEO was the disappearance of Compex’s Milwaukee branch manager. The CEO had been led to believe that the manager had accepted Ivize’s offer of temporary employment during a brief post-closing transition period coupled with a severance payment of one year’s salary. What the CEO didn’t know was that shortly after Ivize and Compex signed a letter of intent on March 5, 2007, Ivize’s Chief Operating Officer and Compex’s CEO told the manager that if the asset purchase transaction successfully closed the combined Milwaukee businesses would be run by his longtime professional rival.
Not surprisingly, the manager bristled at the news that he would soon lose his job to a business competitor. While Ivize conducted due diligence on Compex’s Kansas City and Milwaukee businesses, the manager used his position as a branch manager to undermine the transaction. He immediately informed Compex’s Milwaukee employees of the prospective buyout and told them he intended to start up his own litigation support services company. Over the next several weeks, the manager successfully solicited the top salepeople to join his new venture, held meetings to discuss his business plans on Compex’s premises, redirected some of Compex’s business to his new company, pilfered customer records, and stole company equipment.
Eventually, the CEO succeeded in winning back some of Compex’s former customers, but in spite of his efforts the Milwaukee office’s sales slumped by 45%. Ivize sued Compex in the Delaware Court of Chancery for breaching its representation in the asset purchase agreement that “since April 1, 2007 [Compex] has operated only in the usual and ordinary course.” After reviewing the agreement and the conduct of the parties, the court determined that Ivize had in fact bargained for the physical assets of Compex, such as its computer equipment and office leases, and for “a fair chance at retaining the employees of Compex (who were the “essence” of the business) – not a contractual right to sign the employees to employment and/or non-competition agreements.”
The court explained that Ivize could have structured the transaction so that the execution of employment and non-competition agreements with Compex’s primary salespeople was a condition to closing, which would have strengthened Ivize’s contractual rights under the asset purchase agreement. More important, it would have allowed Ivize to walk away from the deal rather than sink several million dollars into a quickly evaporating pool of goodwill. If Compex’s employees had signed employment and non-competition agreements with Ivize prior to the transaction’s closing, Ivize could have pursued the top salespeople and other defecting employees under the terms of those agreements.
Although the court held that Compex breached its “ordinary course” representation in the asset purchase agreement, it nevertheless declared that “Ivize should not be rewarded with the same damages it would have been entitled to had it structured the agreement properly.” Because Ivize was not able to establish compensatory damages to the court’s satisfaction, the court awarded $1 dollar in nominal damages as a token acknowledgement of a technical injury.
In its opinion, the Court of Chancery focused on how an inadequate deal structure curtailed Ivize’s remedies under the asset purchase agreement. But Ivize’s executive officers could have averted the need for appropriate contractual remedies if they had managed the deal properly. Given that the asset purchase agreement was signed on the transaction’s closing date, the CEO should have ensured that Ivize had executed employment and non-competition agreements with Compex’s key employees in hand prior to signing the agreement. The irony is that while Ivize’s executives recognized the importance of goodwill generated by human capital, they did not understand the nature of goodwill associated with customer relationships and consequently failed to take appropriate actions to protect the company from the inherent dangers in bargaining for such an intangible asset.
