“An earnout often converts today’s disagreement over price into tomorrow’s litigation over the outcome.” Airborne Health, Inc. v. Squid Soap, LP, 984 A.2d 126, 132 (Del. Ch. 2009).
Parties negotiating the acquisition of a company frequently are not able to agree on the purchase price. The reason is that the purchase price should reflect the company value which depends on the company’s business development in the future. The disagreement about the price is caused by different views on the company’s development, in particular if a young company has only a short track record or if the company’s development depends on uncertain future circumstances (e.g. success of new products, granting of an important patent or synergy effects between the target company and the buyer). A possible solution to bridge the gap between the parties’ different views can be a so-called earnout clause. However, in many cases earnout clauses are only a temporary solution as they defer the decision about the appropriate and for both parties acceptable purchase price to the future.
Below, the content of earnout clauses (1.), typical disputes arising out of such clauses (2.) and possible protection measures to mitigate the risk of disputes (3.) are described.
1. Content of Earnout Clauses
An earnout clause is a provision within a sale and purchase agreement (SPA) pursuant to which the parties make a portion of the purchase price subject to the future achievement of specific economic targets by the company; or in legal terms, a part of the seller’s payment claim is made contingent on certain conditions precedent which have to be fulfilled during a defined period, the earnout period, after closing. Such conditions precedent can be for example the achievement of specific revenue, EBITDA or net income results (financial factors) or the acquisition of important new customers, the introduction of new products or the granting of a specific patent (non-financial factors). The earnout amount to be paid by the buyer is often agreed as a multiple or percentage of a financial factor (e.g. 2 times EBITDA over EUR 10 million) or of a combination of different factors. Sometimes, earnout clauses provide for a fixed amount to be paid if a condition precedent is fulfilled.
What sounds so simple in theory bears, in practice, the high risk of post-closing disputes between the parties. Parties should consider carefully whether an earnout clause is an appropriate means in the particular case to bridge the gap as for both parties, earnout clauses offer advantages and create risks. From a seller’s point of view, earnout clauses provide the chance to participate in the company’s future success and to realize a higher purchase price. The downside is that after closing the seller no longer has access to the company’s books and records and is not able to influence the buyer’s business operations. There is thus a risk that the buyer is unable to operate the business successfully or even takes measures to frustrate the fulfillment of the agreed condition precedent or to reduce the earnout amount by influencing the calculation factors.
From a buyer’s point of view, earnout clauses can avoid the risk that the buyer pays too much because certain assumptions upon which the company value and thus the calculation of the purchase price are based prove to be wrong. Furthermore, the payment of a portion of the purchase price is deferred. This provides the buyer with additional financing opportunities. A downside for the buyer can be that the target company cannot be integrated into the buyer’s organization during the earnout period as the target company has to continue to exist for the purpose of calculating the earnout amount. Another downside can be that the seller may participate in the successful development of the company which exclusively results from the buyer’s management and knowhow and could not have been achieved by the seller. If the SPA gives the seller the opportunity to influence the buyer’s business operations, there is a risk that the seller tries to maximize the earnout amount at the target company’s expense.
2. Types of Typical Earnout Disputes
Typical disputes between the parties resulting from earnout provisions fall into the following categories: Either, the parties disagree as to whether the prerequisites for the payment of an additional purchase price set out in the earnout clause have been met or they disagree as to the reasons why the agreed conditions precedent have not been met; or the parties cannot reach an agreement as to how the additional purchase price to be paid by the buyer has to be calculated.
2.1 Dispute About Fulfillment of Condition Precedent
After the closing of the transaction, the parties’ interests can diverge substantially. Whereas the buyer wants to avoid further payments to the seller to the extent possible, the seller wants the company to be managed in a way that maximizes the earnout amount. Sellers have the risk that buyers may take actions post-closing to artificially influence the factors which determine the earnout amount in order to either avert the fulfillment of the agreed condition precedent or to reduce the earnout amount, for example by failing to realize potential business opportunities, shifting sales activities or customers from the target company to another group company or by shifting investment costs or operating or research and development expenses from group companies to the target company. On the other hand, the buyer is faced with a risk that the seller tries to influence the buyer’s business operations in order to maximize the earnout amount at the expense of the company’s long-term development.
The question which business decisions are tolerable and acceptable under the terms of the agreement thus is often a matter of dispute between the parties. The seller will argue that the buyer acted in bad faith in order to discriminate against the seller. Under German law, if a party prevents the fulfillment of a condition in bad faith, the condition is deemed to have been satisfied. In contrast, the buyer will argue that the taken measures fell within its legitimate business judgment and that the non-fulfillment of a condition or a low earnout amount therefore is the consequence of doing business.
2.2 Dispute About Calculation of Earnout Amount
The second category of typical earnout disputes relates to the calculation of the earnout amount. Earnout clauses often provide for a complex calculation formula and combine and weight numerous financial and non-financial factors. Nevertheless, they regularly do not define the calculation rules in great detail and allow for different interpretation possibilities.
Obviously, each party applies the calculation method which serves their particular interests. For example, when preparing the annual accounts (which usually form the basis to determine whether or not the agreed thresholds for the financial factors have been met), the buyer may want to change the accounting principles (HGB, IFRS, GAAP) or apply margins of discretion and accounting options differently than the seller did in order to reduce the earnout amount. For the same reason, the buyer may include in the calculation extraordinary effects, e.g. capital investments or other expenses, which the seller could not take into account when negotiating the earnout clause. Thus, parties often argue about the admissibility of such factors in the calculation.
3. Protection Measures Within the Contract
Except for clear-cut cases, the outcome of court or arbitration proceedings dealing with the disputes described above is hardly predictable. It is therefore recommendable that the parties try to deal with these issues in the SPA to protect the reasonable expectations of the parties and to avoid future disputes.
3.1 Precise Definition of Allowed Business Operations
The SPA should precisely define what the buyer must or may not do during the earnout period in order to prevent the buyer from taking action in bad faith to reduce the earnout amount. As far as possible, general descriptions like “The buyer is obliged to spend reasonable efforts to achieve a target” or “The buyer has to refrain from any action which might hamper the achievement of a target” should be avoided. Courts or tribunals regularly have difficulties to determine which concrete obligations of the buyer resulted from such clauses.
Alternatively or complementary and unless restricted by antitrust law, the SPA could make certain business measures which have the potential to affect the earnout amount significantly subject to the seller’s prior approval. If this is not possible, the parties could agree that certain measures have to be disregarded when calculating the earnout amount. The buyer’s obligations and restrictions have to be balanced against the buyer’s entrepreneurial freedom to operate the acquired company. In particular, the SPA has to ensure that the buyer’s obligations do not unreasonably restrict the scope of allowed business operations and that they will not affect the company’s long-term interest in favor of short-term effects to maximize the earnout amount. No easy task for the transaction lawyers.
3.2 Precise Determination of Calculation Method
With respect to the calculation of the earnout amount, the earnout clause should determine the calculation rules and the accounting method as precisely as possible, in particular the choice of accounting principles, the application of accounting options and the consideration of certain factors in the earnout calculation. If the parties are not be able to agree on detailed calculation rules, the clause should at least determine that the earnout amount shall be calculated on the basis of annual accounts which are “consistent with the company’s historical accounts”. In any event, the parties should choose objective factors which can easily be verified.
Clear specifications help to prevent that the buyer includes surprising parameters into the calculation and ensure that the additional purchase price will be calculated according to the seller’s expectations when the SPA was signed. Such clauses do not limit the buyer’s entrepreneurial freedom. In case the buyer wants to deviate from the method defined in the contract (for example in order to align the target company’s accounts with the company group’s accounts), the buyer would have to prepare two separate accounts – one for the earnout calculation and one as annual account.
3.3 Access Right to Buyer’s Books and Records
In addition, the SPA should include a right of the seller to inspect the buyer’s books and records in order to be able to verify the buyer’s calculation.
3.4 Penalty or Liquidated Damages
A violation of the buyer’s obligations set out in the earnout clause could be sanctioned by a contractual penalty or a claim for liquidated damages. Thereby, difficult calculations of damages and lengthy disputes between the parties about the additional purchase price which the seller has lost due to the buyer’s breach can be avoided.