Introduction
Earn-Outs: A Dealmaker’s Perspective
Earn-outs are an often used and potentially effective mechanism to help bridge the price gap between buyers and sellers. However, there are a number of key considerations regarding earn-outs that, if not properly considered, can lead to suboptimal outcomes.
Problem
Oftentimes, although both buyer and seller are highly motivated, their respective expectations of future financial performance of the target can be meaningfully different, creating a substantial bid-ask spread in the acquisition price.
With both parties highly motivated to finalize the deal, they are eager for ways to bridge that gap. One useful tool in this regard is the “earn-out.” However, for the dealmakers to craft an effective earn-out, they need to understand certain mechanisms of the earn-out. These mechanisms can be:
- structuring considerations;
- dispute resolution;
- valuation considerations; and
- tax considerations, to name a few.
Without grasping these key considerations, the buyer or seller may wind up disadvantaged at the time of the deal or later, when it comes time to realize the earn-out.
Therefore, it is critically important for attorneys and their clients to think through these issues fully.
Solution
Houlihan Lokey, a leading valuation and investment banking firm, has built a wealth of experience in understanding and identifying some of these considerations.
We have prepared highlights of some of the key nuts and bolts of earn-outs. We hope this information will be useful in helping you and your clients think through the various issues that can accompany an earn-out structure.
Overview of Earn-outs: An Abbreviated Summary
This section briefly summarizes the more in-depth information that follows. For more detailed discussion of these topics, see the next section, “Understanding Earn-Outs in Detail.”
An earn-out is a provision in an acquisition agreement that makes a portion of the purchase price payable to the seller if/when certain post-closing performance targets are achieved.
Bridges the Gap Between Buyer and Seller
Situations where the seller’s optimism contrasts with the buyer’s skepticism can often be found in businesses with:
- limited operating history,
- financial distress,
- a historical pattern of not meeting budgets/forecasts,
- an uncertain business environment with unusually high volatility (e.g., COVID-19), or
- an unproven product or new market for an existing product.
Commonly Used
Earn-outs are found in nearly 30 percent of M&A deals, but are more typical in private deals with deal values under $250 million. An earn-out can mitigate risk for the buyer, while giving the seller an opportunity to enhance the aggregate consideration. A poorly structured earn-out can result in mismanagement of the newly acquired business and lead to post-deal disputes.
“[A]n earn-out…typically reflects [a] disagreement over the value of the business that is bridged when the seller trades the certainty of less cash at closing for the prospect of more cash over time…But since value is frequently debatable and the causes of underperformance equally so, an earn-out often converts today’s disagreement over price into tomorrow’s litigation over the outcome.”
The challenge in crafting an earn-out is to reconcile the parties’ competing priorities and their desire to shift as much post-closing risk as possible to the other party.
Buyer Considerations
- Could result in a higher purchase price if the acquired business proves successful
- May result in restrictions in operating the newly acquired business
- The chosen measure for the achievement of earn-out may be poorly defined and not ultimately as meaningful or relevant
Seller Considerations
- Underperformance can lead to reduced purchase price
- Postponing payment increases the risks of external impact adversely impacting the aggregate purchase price paid
- Seller may surrender control to the buyer and/or be adversely impacted by the buyer’s business, making it more difficult to achieve the earn-out
Structuring Earn-Outs
Each earn-out is unique, but several provisions are usually addressed—and if not, post-deal disputes may ensue.
Key Provisions to Be Addressed
- Defining the Business
- Relevant Performance Metrics
- Financial metrics (e.g., revenue, EBITDA, net income, etc.)
- Thresholds
- The required level of the financial metric
- Milestones
- Non-financial (e.g., FDA approval of a drug)
- Measurement Standards
- GAAP and/or exceptions to GAAP
- Form of Consideration
- Earn-Out Period
- Buyer/seller considerations with respect to the period
- Sufficient to assess performance of the business
- 1–3 years is common
- Operational Control
- Critical Issue: buyer flexibility to run the business versus the seller’s desire to maximize the earn-out
- Payout Formula
- Binary
- All or nothing; more common with milestones
- Graduated (e.g., [x]% of adjusted EBITDA)
- Multiple (e.g., milestone plus a revenue threshold)
- Caps/floors
- Maximum/minimum payouts under the earn-out
- Payout schedules
- One or several payouts
- Indemnification
- Offsets against amounts due to the buyer
Dispute Resolution
A large body of Delaware case law suggests that earn-outs tend to only postpone disputes because cases typically involve a business’s failure to meet earn-out criteria. Key considerations concerning earn-out-related disputes include payout calculation, arbitration vs. litigation, and breach of contract or breach of the implied covenant of good faith and fair dealing.
Delaware courts interpret earn-out provisions literally, and intent of the parties is paramount. Resorting to good-faith provisions can be problematic. Sellers may claim, among other things, that the payout calculation was incorrect or there were certain breaches by the buyer.
Payout Calculation Disputes
If the buyer and seller disagree initially on the payout calculation, the agreements typically would call for an expert or arbitrator (a “neutral”) to make a final determination. (An expert or arbitrator is an important distinction with significant consequences.)
Note, Delaware courts will not lightly intervene in payout calculation disputes, which may lead to pursuit of other legal actions. Therefore, it is important for the agreement to distinguish payout calculation and other causes of action, which would be resolved in a different manner.
Payout Calculation Considerations
Relevant concerns that should be addressed in the provisions regarding the payout provisions include:
- how the neutral will be selected
- the scope of review and whether the neutral will be an expert or arbitrator
- who pays
- whether the neutral will be bound by methodologies provided for in the agreement or can raise issues beyond those identified by the parties
- the timetable
- the basis for dispute of the neutral’s conclusion
Agreements sometimes include mandatory arbitration as the primary means of dispute resolution. However, litigation may arise over whether a court or an arbitrator has jurisdiction to make certain determinations.
Arbitration vs. Litigation
Some advantages of arbitration include speed, cost-effectiveness, and enhanced confidentiality. However, some advantages of litigation may include discovery, definitive resolution, availability of appeal, and alleviation of concerns over arbitrator competency or seeking a compromise value.
Breach of Contract
Losing sellers sometimes recast claims in a subsequent lawsuit alleging breach or express or implied obligations. This is a high bar. Delaware recognizes an implied covenant of good faith and fair dealing, which serves as a gap-filling role. Sellers will argue that the buyer may not undermine the business and that the implied covenant might obligate the buyer to take reasonable measures to achieve the earn-out. Buyers argue that there are no gaps to fill and that the implied covenant does not provide protections not secured at the time of the original agreement.
Valuation of Earn-Outs
There are a number of considerations for how an earn-out is treated for accounting purposes, and there are multiple ways to value the earn-out.
Accounting Treatment
An earn-out is treated as a liability if payment involves cash or variable number of shares. The liability must be remeasured to fair value at each reporting period until contingency is extinguished and associated change is recorded as a gain or loss on the income statement. If opening liability is greater than the payout, a loss is recorded, or vice versa. If payment involves a fixed number of shares, it is treated as equity.
How an earn-out is treated can impact the buyer’s income statement (e.g., EBITDA) and, thereby, may have an impact on certain other aspects of its business (e.g., bank financial covenant measurements).
Earn-Out Methodologies
There are two different valuation methodologies: the scenario-based method (SBM) and the option pricing method (OPM). In the SBM, multiple scenarios are identified. A payout is calculated for and a probability assigned to each, and an averaged payout is discounted at a risk-adjusted discount rate.
The OPM is better suited for non-linear payout structures or when multiple metrics involved. It treats earn-outs like a call option and employs option pricing models (e.g., Black-Scholes).
Tax Issues
The parties may have adverse tax interests in the characterization of payouts, so the treatment of the earn-out should be addressed as early as possible.
Tax Considerations for Parties
- Compensation or purchase consideration
- Compensation taxed as ordinary income to the seller, with a deduction for the buyer
- Consideration taxed as capital gain to the seller, and the cost is capitalized for the buyer
- Magnitude of payout
- Should any tax sharing agreements be factored in as part of achieving thresholds?
IRS Considerations
- Is the seller required to provide services to be eligible for payout?
- Is the seller otherwise adequately compensated for services?
- Are payouts proportionate to seller’s equity?
- Do total payouts represent a reasonable price paid to seller?
- What is the compensation of non-selling carryover employees?
- How is the earn-out treated for tax and financial reporting purposes?
Contingent Value Rights
Contingent Value Rights (CVRs) represent a version of the earn-out in transactions involving publicly traded companies, and they are particularly common in the pharma-life sciences sector.
Tax Considerations for Parties
- Typically, shorter in duration than traditional earn-outs and tied to an objectively verifiable outcome (e.g., FDA approval of a new drug).
- Can be considered a security, subjecting it to registration requirements of the Securities Act
Five Factors
The SEC sets out five essential factors for CVRs not to be considered a security:
- Integral part of transaction
- Not represented by any form of certificate or instrument
- No rights common to stockholders (e.g., voting) and does not bear a stated interest rate
- Does not represent an equity or ownership interest
- Not transferable
Understanding Earn-Outs in Detail
What Is an Earn-Out?
- An earn-out is a provision in an acquisition agreement (the agreement) that makes a portion of the purchase price for a target company or business (the business) payable to the seller of the business (the seller) based on the post-closing performance of the business.
- Twenty-seven percent of the deals in the ABA’s 2018–1Q2019 Private Target M&A Deal Points Study (the ABA Study) featured an earn-out.
- Earn-outs most often are found in private company acquisitions with a value of under $250 million.The size of an earn-out relative to the total consideration in the transaction will typically reflect the magnitude of the disagreement between the parties with respect to the value of the business. An earn-out representing less than 15 percent of the purchase price may not be worth the time and effort to negotiate the earn-out provisions and/or the risk of future litigation.
- Payments of deferred purchase price and post-closing purchase price adjustments are not earn-outs.
- A purchase price deferral is effectively a loan by the seller of a portion of the purchase price to the buyer of the business (the buyer).
- Purchase price adjustments reflect changes in the working capital of the business between the signing of the agreement and closing and can increase or decrease the purchase price for the business, whereas earn-outs will only increase the purchase price in the future.
- An earn-out in the context of a public company acquisition is known as a “contingent value right.” See the “Contingent Value Rights” section later in this article for more information.
When to Use an Earn-Out
- Earn-outs can potentially bridge a gap between parties with differing views as to the business’s prospects and/or value.
- An ex post “true-up” allows the parties to agree to disagree and complete the acquisition of the business (the acquisition).
- Among other things, earn-outs may be particularly useful in situations involving a(n):
- Business with a limited operating history but with significant growth potential,
- Uncertain economic environment or a highly volatile industry,
- Business with a historical inability to achieve its projections,
- Unproven product or a new market for an existing product,
- Business having recently undergone a financial or operational restructuring,
- Company that has experienced a recent drop in earnings that may be temporary (e.g., due to COVID-19),
- Business that is dependent on relatively few customers, or
- Buyer with limited access to debt financing.
- Properly structured, an earn-out can produce a win-win situation for both seller and buyer.
Advantages of an Earn-Out to the Buyer
Earn-out payments can be used to secure the seller’s indemnification obligations under an agreement. They provide the potential for greater aggregate consideration than in a fixed price structure (especially for the seller of a financially distressed business). And earn-out payments may allow the seller to benefit from synergies achieved by integrating the business with the buyer, allow for deferral of taxes (see the “Tax Issues” section for further discussion), and may allow the seller to control its own destiny if the incumbent management manages the business post closing.
Considerations Regarding Earn-Outs
A poorly crafted earn-out can result in mismanagement of the business and can create contentious post-deal disputes. As Vice Chancellor Laster of the Delaware Chancery Court (the Court) observed in Airborne Health:
“[A]n earn-out…typically reflects [a] disagreement over the value of the business that is bridged when the seller trades the certainty of less cash at closing for the prospect of more cash over time…But since value is frequently debatable and the causes of underperformance equally so, an earn-out often converts today’s disagreement over price into tomorrow’s litigation over the outcome.”
The challenge in crafting an earn-out is to reconcile the parties’ competing priorities and their desire to shift as much post-closing risk as possible to the other party.
Buyers will want to (i) control the post-closing activities of the business and (ii) minimize the future earn-out payments. Sellers will want the buyer to (i) actively pursue the growth of the business and (ii) maximize the future earn-out payments. Structuring an earn-out usually involves complex accounting, valuation, and tax issues that require the involvement of expert advisors. Because it is impossible to anticipate and address every scenario that could impact the earn-out, there is usually a “trust-me” aspect to the negotiation.
Buyer Considerations
- If the acquisition is successful, the buyer may pay more for the business than if it had paid a higher price up front.
- An earn-out may impose restrictions and covenants on the buyer, including restrictions on integrating the business.
- The seller may benefit from enhancements to the business contributed by the buyer after closing.
- Due to unexpected changes, the chosen measure of success at closing may not be a relevant metric in the future.
- If incumbent management continues to operate the business, short-term, earn-out targets may undermine the buyer’s long-term goals.
Seller Considerations
- If the business underperforms, the seller will receive less consideration than anticipated.
- The seller may lose the ability to influence decisions that affect the achievement of the full earn-out.
- The business may be affected by exogenous post-closing factors that were not anticipated when the agreement was signed.
- The buyer may not be motivated to improve the performance of the business during the pendency of the earn-out period.
- Financial support from the buyer may be critical to achieving the business’s projections.
- The seller is likely to lose custody of the books and records of the business (see Windy City).
- The seller is vulnerable to the credit risk of the buyer.
Structuring Earn-Outs
Earn-outs are bespoke provisions; however, several key areas are typically addressed:
- definition of the business on which the earn-out will be based,
- relevant performance metric(s),
- appropriate target(s) for achieving the earn-out,
- amount to be paid if the earn-out target(s) are achieved (the payout),
- appropriate standard for measuring the performance of the business (the performance metric),
- formula that will quantify the payout,
- appropriate time period for achieving the earn-out (the earn-out period),
- allocation of post-closing control of the business, and
- mechanisms for dispute resolution.
Defining the Business
If operated ex post as a subsidiary or segregated division, measuring the business’s performance should be relatively straightforward. Integration of the business with the buyer can make a pre- and post-comparison of performance of the business difficult.
The following matters, among others, should be considered in defining the business:
- the specific line(s) of business to be included (by business line, customer type, price point, or region, etc.) (See Windy City);
- whether expansion of the business by the buyer will count toward the earn-out (see Glidepath and Western Standard); and
- the treatment of revenue from pre-closing customers common to the business and the buyer.
Performance Metrics
The performance metrics can be (i) financial, (ii) non-financial, or (iii) a combination of both.
Financial Performance Metrics
Financial performance metrics include income statement line items (for example, net revenues, EBITDA, net income), balance sheet items (e.g., net equity), or other performance metrics (such as buyer’s stock price).
Sellers prefer revenue-based performance metrics, which are less impacted by expenses and buyer post-closing accounting practices.
Buyers, on the other hand, prefer income performance metrics, as they can be better indicators of the success of the business. Buyers are more likely to insist on net income if incumbent management will operate the business post closing (to incent cost control).
Earnings before interest, taxes, and depreciation and amortization (EBITDA) is a commonly used financial performance metric. Because the aggregate purchase price is often calculated as a multiple of EBITDA, it is logical to use the same measure for the earn-out.EBITDA is not defined under generally accepted accounting principles (GAAP) and may not be presented in the historical financials of the business. Accordingly, the items to be included/excluded in calculating EBITDA need to be clearly specified in the agreement.
Thresholds
The earn-out threshold (the threshold) is the financial performance metric level that the business must achieve for the seller to receive a payout. Thresholds are typically based on the seller’s projections for the business (the projections). Thresholds should be objective and measurable, plainly defined, and consistent with the character of the business.
Milestones
Non-financial performance metrics commonly include regulatory approval or the launch of a new product (a milestone and, together with a threshold, a target). Milestones obviate many of the complexities associated with structuring financial thresholds. However, an issue can arise as to whether a milestone can be achieved in part, but not in whole, (e.g., if only some of the claims of a patent are granted (see Gilead Sciences and Allergan)).
Milestones are especially useful in the context of emerging companies, where setting financial thresholds may be challenging due to the high growth trajectory of the business and/or the lack of historical information to use as a baseline. Milestones are most frequently observed in life sciences (FDA approval of a drug) and in technology (receipt of a patent).
A milestone structure requires the parties to agree on:
- the specific milestone (see Gilead Sciences),
- the specified degree of buyer efforts to cause, or to cooperate in causing, the milestone event to occur (see Allergan), and
- any deadline by which the milestone must occur (see Shire).
The most successful milestone is either an event over which neither the buyer nor the seller has any control or an event that is so important, the buyer remains motivated to see that event occur, despite the obligation to make the milestone payout.
The parties should be very specific as to what types of approval satisfies a milestone. The use of industry and colloquial terms in defining the milestone (on the assumption everyone knows what is meant) can lead to subsequent disputes (see Valeant). Examples should be included in the agreement of what will, and what will not, satisfy the milestone (see Shire and Tutor Perini II). Parties should also ensure that documents outside the agreement, such as term sheets and board presentations, clearly and consistently describe any milestones.
Measurement Standards
Earn-outs based on financial performance metrics require that the post-closing financial statements allow the performance of the business to be accurately compared to the relevant threshold.
The seller’s goal will be to ensure that the earn-out calculation provides an “apples-to-apples” comparison between the pre-closing and post-closing performance of the business. The baseline methodology is usually GAAP, applied consistently with the seller’s pre-closing practices.
Reference to GAAP alone, however, is insufficient, as GAAP permits a wide range of accounting policies (see Chambers).
Some of the accounting issues that are commonly prone to dispute include, among others:
- inventory valuation: excess and obsolescence reserves (see Winshall I);
- collectability of accounts receivable and bad debt allowances (see Tutor Perini II);
- current expense versus capitalization (see Chambers);
- reserves for warranty and product returns and for pension and post-retirement benefits;
- contingencies such as litigation and environmental clean-up; and
- changes to conform to newly promulgated GAAP.
The parties and their advisors need to identify and agree on line items that will be a supplement (or an exception) to GAAP. Adjustments specified in the agreement take precedence over GAAP (see Chambers and LaPoint). The agreement should set forth in detail how the financial performance metric should be calculated, including how specific line items would impact the calculation. Illustrative calculations can be helpful in resolving later disputes (see Tutor Perini I). In particular, matters commonly addressed in determining a financial performance metric include, among others:
- costs and expenses incurred in connection with the acquisition (see Chambers and Comet Systems);
- allocation of intercompany overhead for home office services;
- determination of appropriate transfer pricing in intercompany transactions;
- treatment of extraordinary or non-recurring items of gain or loss (see Comet Systems);
- revenues and expenses from new lines of business not contemplated by the agreement;
- capital expenditures and R&D costs, the benefit of which accrue after the earn-out;
- management or other fees charged to the business;
- the treatment of discontinued operations; and
- the treatment of synergies arising from the acquisition.
Payout Formula
Once the performance metric(s), threshold(s), and measurement standards are established, the parties need to agree on whether the payout will be structured as a fixed percentage of an underlying performance metric or as a complex, nonlinear function of the underlying performance metric, which can feature floors, caps, and catch-up or make-whole provisions (the payout formula).
Binary Payout Formulas
Under a binary or an “all-or-nothing” payout formula, a lump sum is payable only upon the achievement of a stated target (e.g., $10 million upon the launch of Product X). Binary payout formulas are more commonly found in earn-outs with non-financial milestones, such as regulatory approvals. A binary payout formula can incentivize the buyer or an incumbent management to take actions to miss or achieve the threshold, as the case may be. A binary payout formula can demotivate an incumbent management when it becomes apparent that the business will not be able to achieve a required target.
Graduated Payout Formulas
Given the negative incentives of a binary payout formula, sellers will try to negotiate a payout formula that is a percentage of the performance threshold (e.g., “the annual payout shall equal 5 percent of adjusted EBITDA” or a graduated payout formula). Graduated payout formulas are relatively uncommon, as buyers resist paying for performance that does not achieve the relevant target.
The compromise is to set a minimum threshold (e.g., “the payout shall be 15 percent of the excess of 2021 EBITDA over $5 million”).
Multiple Payout Formulas
Payout formulas can include more than one performance metric (e.g., satisfaction of two of the following: (i) a revenue threshold, (ii) an EBITDA threshold, and/or (iii) retention of X% of the business’s customers).
Multiple performance metrics reduce the opportunity for a buyer or an incumbent management to manipulate the earn-out.
Caps and Floors
The payout in an earn-out can become substantial if the achieved performance metric exceeds the threshold by a significant amount. Buyers will want to cap the amount of each payout or the aggregate of all payouts (see Tutor Perini and Windy City). Sellers will try to resist any caps and will try to negotiate for a minimum floor payout (see Windy City).
Including floors and caps narrows the range of potential discrepancy that can be subject to subsequent dispute.
Payout Schedule
Payouts may be in one payment at the end of a short earn-out period or in periodic installments over a longer earn-out period. Multiple installment payouts raise a number of complicated issues:
- The buyer may want to set near-term payouts at a lower percentage than later ones to protect against future shortfalls but, conversely, may want to decrease the payout over time to reflect any synergies from integrating the business with the buyer.
- If the business fails to achieve the threshold in one period but exceeds it in the following period, the buyer may require that the seller make up the prior deficiency before becoming entitled to receive the current year payout.
- Similarly, if the business achieves the threshold in an earlier period but fails to achieve it in later periods, the buyer may seek to “claw back” all or a portion of the prior year payout.
- Conversely, the seller will want to be able to make up any deficiencies in performance in one period with any excess in a prior or later period to achieve the target for the deficient period (see Tutor Perini).
Such complexities can be avoided through the use of a cumulative approach, which depends on the extent to which the average results during the earn-out period exceed a specified cumulative threshold.
Interaction with Indemnification
The agreement should specify any interaction between the seller’s indemnification obligations and the earn-out provisions. Buyers will want the right to offset payouts against amounts due pursuant to the seller’s indemnity under the agreement.Buyers will resist having the earn-out be the sole source of indemnity payment inasmuch as the earn-out may never be earned. Sellers will want to ensure that a given event does not give rise to both an earn-out offset and a separate indemnity claim.
Form of Consideration
Payouts may take the form of cash or non-cash consideration, such as a buyer note or stock, or both. If the consideration is cash or a buyer note, the seller will assume the buyer’s credit risk and will want assurances that the buyer will be able to make required payouts when due, and they may request security in the form of an escrow.
Sellers will want to ensure that the buyer’s credit facilities (existing and, if possible, future) will not impact the buyer’s ability to make the required payouts when due. The seller may ask for interest to begin accruing at a punitive rate if the buyer does not make a required payout when due.
If payouts are to be made in buyer stock, the agreement will need to address a number of issues pertaining to:
- the date as of which the value of the buyer stock will be measured (e.g., the closing or issue date),
- the seller’s registration rights, if any,
- any voting restrictions/requirements,
- tag-along/drag-along rights,
- repurchase right by the buyer,
- restrictions on transferability, and
- anti-dilution protection.
If the buyer is a private company, the parties will need to specify a valuation methodology (e.g., formula or third-party valuation). The seller will want to ensure that the maximum number of potentially issuable shares of buyer stock are reserved at closing and any required stockholder approvals are secured.
Securities Law Issues
The Securities Exchange Commission (SEC) has issued numerous no-action letters on the subject of whether an earn-out is a security and considers many factors when making this determination, including whether:
- the earn-out is an integral part of the consideration to be received in the acquisition;
- the earn-out right is represented by any form of certificate or instrument;
- the holders of the earn-out have rights in common with stockholders (for example, voting and dividend rights);
- the earn-out represents an equity or ownership interest in the buyer; and
- the earn-out is transferable.
The Earn-Out Period
Once the appropriate performance metrics, targets, and payout formulas have been agreed upon, the parties will need to consider the length of the earn-out period, the end of which may be triggered by the passage of time or the occurrence of an agreed-upon event. The earn-out period should be sufficient to adequately assess the performance of the business. An earn-out period that is too short carries the risk that performance of the business may be distorted by temporary short-term factors, such as COVID-19 or a drop in the price of oil. An earn-out period of one to three years after closing is common.
Buyer Considerations
Buyers prefer shorter earn-out periods to minimize the duration of any restrictions on their management of the business. The buyer may want an early buyout option in the event the earn-out hinders the buyer’s ability to operate the business. Ideally, the price of any buyout should be a fixed dollar amount to avoid interim payout calculation disputes. However, if incumbent management is to manage the business, an earn-out period that is too short might provide an incentive to sacrifice the buyer’s long-term interests for short-term profits. If financing is an issue, the buyer may prefer a longer earn-out period to have more time to actually make the required payout.
Seller Considerations
A shorter earn-out period can result in an earlier potential payout.
If incumbent management is running the business post closing, a longer earn-out period will provide more time to achieve the relevant target; however, a longer earn-out period reduces the present value of the consideration ultimately received. Sellers will want to include a provision that accelerates the payout upon the occurrence of certain events that might negatively impact the ability of the business to achieve its target, including, among other things:
- a sale of all or a substantial portion of the business,
- a change in control of the buyer,
- a default under any of the buyer’s credit facilities or other material contracts, and
- termination of incumbent management for any reason.
Operating Control Issues
Two of the most difficult, albeit most important, aspects of structuring an earn-out are determining:
- the degree of control (if any) that the seller will have over the business post closing, and
- the level of support (if any) that the buyer will be obligated to provide to the business.
Balancing the buyer’s desire to run the business as it sees fit and the seller’s desire to protect the business’s ability to achieve its target(s) can be difficult and often leads to disputes.
Buyer Considerations
- The buyer will want to negotiate for:
- the right to operate the business in its sole discretion (see LaPoint) and
- a disclaimer of fiduciary duty to the seller regarding the earn-out.
If the business is to be run by an incumbent management, the buyer will want covenants and restrictions in the agreement to ensure the business is not operated solely to maximize the payout through risk-taking or failure to invest. An incumbent management may face potential fiduciary duty conflicts. As employees of the buyer, incumbent management will have an obligation to do what is best for the parent corporation, even if that means taking actions that could adversely affect the business and reduce the likelihood of receiving a payout.
Seller Considerations
Sellers will seek to impose certain restrictions on a buyer’s operation of the business, including obligations for the buyer to:
- run the business to maximize the earn-out,
- operate the business consistent with past practice,
- use “commercially reasonable” efforts to achieve a target (see Allergan),
- not take any action with the intent of decreasing the amount of any payouts,
- provide the business with appropriate levels of working capital and capital expenditures,
- maintain the existing research and development programs, and
- not divert business to other entities controlled by the buyer.
The seller will also try to reserve some authority regarding major decisions by the buyer, including restrictions on:
- disposing of all or a significant portion of the business,
- hiring or firing of incumbent management,
- restrictions on dividends from the business,
- incurrence of additional debt, and
- combining all or a significant part of the businesses with another company or business.
Dispute Resolution
Unfortunately, as observed by Vice Chancellor Laster in Airborne Health, earn-outs often merely postpone disputes, as is evidenced by the large body of Delaware case law respecting earn-outs. Though fact-specific, the cases usually involve a failure of the business to meet its target, followed by the seller’s claim the:
- payout calculation was incorrect,
- buyer breached the agreement, and/or
- buyer breached the implied covenant of good faith and fair dealing (the implied covenant).
As with other contract provisions, when Delaware courts interpret earn-out provisions, the intent of the parties is paramount. An agreement’s plain language will be enforced notwithstanding a windfall to one of the parties (see Chambers and LaPoint). If the agreement is unambiguous, extrinsic evidence as to the intent of the parties will not be admissible (see Exelon Generation).
Ambiguous provisions are likely to result in a trial (see Stora Enso, Western Standard, and Windy City). The Court is unlikely to aid a sophisticated party that could have, but failed to, negotiate contractual protections (see Airborne Health). Recognizing the futility of trying to provide for every contingency, parties often resort to good-faith provisions in the agreement (usually at the seller’s request). The Court has criticized such provisions as “gossamer definitions” and “aspirational statements” that are “too fragile to prevent the parties from devolving into…dispute” (see LaPoint).
Payout Calculation Disputes
In the typical scenario, the buyer’s accountants prepare the post-closing financial statements and calculate the payout amount. The seller then has a period of time either to submit a notice of disagreement or to accept the calculation as final and binding. The buyer will often try to limit the seller’s scope of objections to factual or numerical mistakes, or inconsistencies with the agreement.
Failing a negotiated resolution of any disputes, the agreement frequently provides for the parties to jointly select an accountant from a third independent accounting firm (a neutral accountant), whose determination will be final. Whether a chosen neutral accountant is denominated as an expert or as an arbitrator can have serious ramifications. See Chicago Bridge & Iron Co. N.V. v. Westinghouse Elec. Co. LLC, 166 A.3rd 912 (Del. 2017) (Chicago Bridge). An expert determination is merely a determination of a specific factual issue that the agreement requires to be determined by an expert.
In contrast, an arbitrator’s powers are analogous to those of a judge and include, among other things, the power to interpret contracts, resolve factual disputes, determine liability, and award damages. An arbitrator’s award is enforceable by a court, with limited right to appeal or review under the Federal Arbitration Act (FAA).
Delaware courts will not lightly intervene in disputes over payout calculations when the agreement provides for arbitration and is likely to treat a neutral accountant’s resolution as final. The Delaware Supreme Court (DSC) has held that the courts have no role in considering disputes where the “plain language of the…agreement” made arbitration by [a neutral accountant]…the “mandatory path” for resolving disputes over a post-closing adjustment. (See Chicago Bridge. See also MarkDutchCo.)
There are important differences between a payout calculation (addressed by the neutral accountant) and potential causes of action, such as fraud or a breach of the agreement, which are not suitable for expert determination. The agreement should carefully distinguish and separate payout calculation disputes from such other potential issues. Relevant concerns in drafting a payout calculation dispute provision will include:
- how the neutral accountant will be selected,
- the scope of review by the neutral accountant (solely the payout calculation as an expert or “any and all disputes” as an arbitrator),
- who will pay for the neutral accountant (the loser, or shared equally or proportionally) (see MarkDutchCo),
- whether the neutral accountant is bound by the methodologies provided in the agreement,
- whether the neutral accountant can raise issues beyond those identified by the parties (see Chicago Bridge),
- what work papers will be provided in support of the neutral accountant’s calculation,
- whether the neutral accountant is free to perform a de novo calculation to derive its own result,
- a timetable for the process, and
- the basis on which, if any, a party can bring a claim to dispute the neutral accountant’s determination.
The neutral accountant’s engagement letter is important because the scope of its mandate can be opened up beyond what was contemplated in the agreement if the parties agree to a wider scope in the engagement letter.
General Arbitration vs. Litigation
Agreements sometimes include mandatory arbitration as the primary means of dispute resolution. Factors favoring arbitration over litigation include speed, reduced expense, and enhanced confidentiality. On the other hand, factors favoring litigation include more expansive discovery, definitive resolution of legal issues, the availability of plenary appeal, concern over the competence of the arbitrator pool, and concern that an arbitrator will gravitate toward compromise outcomes.
Litigation can arise over whether a court or an arbitrator has jurisdiction to make certain determinations. The DSC has stated that:
“Issues of substantive arbitrability are gateway questions relating to the scope of an arbitration provision and its applicability to a given dispute, and are presumptively decided by the [C]ourt. Procedural arbitrability issues concern whether the parties have complied with the terms of an arbitration provision and are presumptively handled by arbitrators. These issues include whether prerequisites such as time limits, notice, laches, estoppel, and other conditions precedent to an obligation to arbitrate have been met, as well as allegations of waiver, delay, or a like defense to arbitrability.” (See Winshall I)
Once jurisdiction has been resolved, a Delaware court will likely take an expansive view of the competence of an arbitrator to decide a broad range of matters, including procedural questions as well as interpretation of the agreement and applicable law. Many of the same considerations apply to the appointment of a general arbitrator as pertain to the retention of a neutral accountant. If the agreement allows recourse to litigation, jurisdiction and venue should be clearly specified.
Breach of Contract
Losing sellers in payout calculation disputes often try to recast their claims in a subsequent lawsuit alleging that the failure of the business to achieve a target was due to the buyer’s breach of an express or implied obligation under the agreement.
Sellers (as the usual plaintiff in these cases) face an uphill battle in proving not only the buyer’s misconduct but also that such misconduct caused the business to miss its target. (See LPL Holdings and En Pointe.) The high bar results in many earn-out cases being dismissed at the motion to dismiss or summary judgment stage.
Delaware courts often hold that the buyer’s conduct reflected the exercise of legitimate business judgment and that the seller’s complaint is merely a dispute over business strategy. (See Lazard Technology, Boston Scientific, and Glidepath.) However, a claim based on the manner in which the business was operated post closing may involve factual determinations that will preclude a successful motion to dismiss. (See Edinburgh Holdings and Cephalon.)
Proving whether the seller has been damaged—and in what amount—requires expert testimony, especially when the business is a startup or has a limited track record, which makes it difficult to quantify how the buyer’s actions or inactions harmed the business. It can be difficult to prove that targets would have been reached but for breaches by the buyer, and the Court may be reluctant to speculate what the payout would have been in the absence of the breach. (See LaPoint and LPL Holdings.) The seller might consider seeking to specify remedies for breaches of any of the obligations or restrictions regarding the post-closing operation of the business—such as liquidated damages or payment of the maximum payout.
Breach of the Implied Covenant
Delaware recognizes an implied covenant that “requires a party in a contractual relationship to refrain from arbitrary or unreasonable conduct which has the effect of preventing the other party to the contract from receiving the fruits of the bargain.” (See Winshall II.) The implied covenant serves a gap-filling function where the parties to the agreement did not anticipate some contingency, and had they thought of it, the parties would have agreed at the time of contracting to address that contingency. (See LPL Holdings.)
Sellers will argue that a buyer may not undermine the business and thereby deprive the seller of its “fruits of the bargain,” i.e., a payout. Sellers often further argue that the implied covenant obligates the buyer to take “reasonable” or even “best efforts” to reach a target.
The Court has held that the implied covenant does not impose a duty on a buyer to maximize an earn-out and does not “give the plaintiffs contractual protections that ‘they failed to secure for themselves at the bargaining table.’” (See En Pointe and Winshall II.) On the other hand, the Court is not tolerant of actions by a buyer that demonstrate an attempt to divert resources, opportunities, or revenue away from the business to avoid paying an earn-out. (See LPL Holdings and Haney.) Buyers defend against implied covenant attacks by emphasizing that the implied covenant is inapplicable when “the subject at issue is expressly covered by the contract.” (See Airborne Health, Lazard Technology, and Dialog Semiconductor.)
However, the Court has sometimes recognized claims for breach of the implied covenant where “the contracting parties would have agreed to proscribe the act later complained of…had they thought to negotiate with respect to that matter.” (See Winshall I.) The Court will not countenance a claim for breach of the implied covenant if such claim is duplicative of a related breach of contract claim. (See Edinburgh Holdings.)
