Making M&A Earnouts That Work

Disagreements over the purchase price in a company acquisition often come from differing views of the target’s future performance and cash flows. To get the deal done parties bridge their valuation differences by agreeing to an earnout. They set standards for the company’s post-closing performance and measure them after closing. The seller gets more money if the post-closing performance confirms its position.

The problem is the earnout clause written often leads to litigation over whether the earnout was met or why it was not met. Estimates are that 60% of all merger and acquisition litigation is over earnout issues. Careful drafting and consideration of all the ways it could go wrong can change the result of that litigation. More importantly, it could prevent it from happening at all.

In one case, a seller argued that the implied covenant of good faith and fair dealing meant the purchaser was required to maximize an earnout provision in an asset purchase agreement. The seller said the purchaser breached the duty by maintaining financial records in a way that made it impossible to accurately determine the correct amount of earnout payments; creating a sham entity to move revenue off the books; and renewing certain contracts or transferring sales persons or accounts as a way to minimize adjusted gross profit.

The APA said that the purchaser would have sole discretion about all matters relating to the operation of the business. The contract said the purchaser had no express or implied obligation to the Seller to seek to maximize the earnout payment.

The purchaser moved to dismiss the case saying the sole discretion provision defeated any implied covenant claim. The court agreed. The comprehensive and explicit terms demonstrated the parties contemplated a dispute concerning the operation of the business post-closing, specifically whether the purchaser was acting in a manner that maximized the earnout. The terms that granted broad rights to the purchaser to operate the business as it saw fit meant the implied covenant could not give the seller rights it had failed to secure for itself at the bargaining table.

In a second case, the specific contract language imposing post-closing obligations on the purchaser led to a different outcome. An earnout agreement contained three provisions addressing the purchaser’s post-closing obligations.

• First, although it had the power to direct the management, strategy, and decisions post-closing, the purchaser agreed it would act in good faith and in a commercially reasonable manner to avoid taking actions that would reasonably be expected to materially reduce the earnout.

• Second, the purchaser agreed to act in good faith and use commercially reasonable efforts to present and promote the acquired company’s products to customers that could reasonably be expected to use them.

• Third, the purchaser agreed to upgrade or build a bridge between the companies’ systems, within six months of closing, to allow the sale of the acquired products to its existing customers and assist in calculating the earnout. In a lawsuit asserting noncompliance with the earnout agreement, the seller asserted breach of contract. The court denied the purchaser’s motion to dismiss for some of the seller’s earnout allegations, focusing on the first and third obligations in the earnout agreement.

The court viewed the first obligation as a requirement to refrain from positive actions that reasonably could be expected to reduce the earnout or impede calculating the earnout. That did not extend to avoiding inaction because extending that obligation would place the power to manage the company in the hands of the seller. The claims that survived the motion to dismiss focused on positive actions like routinely cancelling regularly scheduled calls to prevent the seller from promoting and selling the products and improper accounting decisions concerning minimum thresholds for bills and diverting revenue to different products to avoid paying the earnout.

On the third obligation, the purchaser argued the seller could not show damages resulting from the purchaser’s decision to build an alternative bridge between the parties’ systems. The court concluded it was reasonable to infer from the agreement that a specific solution was necessary to provide services to customers and calculate the earnout amount and failing to build that solution could be damages.

These decisions show how courts understand the incentives and details of earnout provisions and hold parties to their bargain. Concessions might get the deal done, but purchasers must understand they may be agreeing to restrictions on how they run the business post-closing. The opposite is true for sellers who could give away their ability to hold purchasers accountable post-closing.

Purchasers face more risk and sellers have stronger leverage from specific provisions that impose post-closing obligations on the purchaser. Earnout provisions that do not require specific obligations or grant the purchaser significant discretion to operate the business create problems for sellers who have an uphill climb. Courts may refuse to use an implied covenant to give parties contractual protections they failed to secure for themselves at the bargaining table.