Earn-outs in M&A: Managing Disputes Risk

In challenging economic conditions, earn-out mechanisms are being used to bridge divergent views as to the proper valuation of a business. The negotiation and drafting of the mechanism can be fraught with complexity. In this note, our transactional and contentious teams have identified the key issues involved in drafting an earn-out mechanism and the disputes risks that can arise, and will need to be managed, as a result.

Earn-out mechanisms have long been used to calculate the price ultimately payable by a buyer in respect of a share or asset acquisition, with reference to the performance of the business after the date of the acquisition.?Traditionally a key feature of an earn-out has been to tie the sellers to the target business for a certain period and incentivise them to continue to drive the success of the business after the sale.

A current trend is for earn-outs to be used when the sellers are to have no ongoing role in the business, to bridge divergent views as to the proper valuation of a business.?The potential advantages are clear:

• For a buyer, such mechanisms can ensure that the price paid more closely reflects the actual performance of the target business after the completion, mitigating some of the uncertainties inherent at the time of the purchase of a business.?The deferral of a portion of the consideration may also give rise to a cash flow advantage.
• For a seller, the mechanism can provide the opportunity to translate the inherently uncertain projections for the future performance of the target business into cash, if the company performs as they expect it to.

At the same time, the parties may approach an earn-out from different conceptual perspectives: buyers will view future payments as highly contingent, while sellers may feel an entitlement to payments which they regard as merely deferred.

This fundamental tension has implications for the (often fraught) negotiation and drafting process that surrounds an earn-out.?

The operation of an earn-out mechanism can be complex and can generate additional risk of disputes between buyers and sellers.?Some of the most significant and frequently disputed issues associated with earn-out mechanisms are discussed below.

Earn-out period

Parties need to agree the period of business operations to which the earn-out will apply (usually referred to as the ‘earn-out period’).?Our M&A Market Monitor report, which tracks international M&A trends across the transactions we advise on, shows that the majority of the earn-outs we see on UK and US deals apply a period of 1–2 years. The trends elsewhere in Europe and in Asia are towards slightly longer periods (often between 2 and 3 years).

Conduct of the target business post-acquisition

A seller counting on a significant pay-out under an earn-out is vulnerable to the decisions made by a buyer as to how it operates and manages the target business following the acquisition.?A buyer could be motivated to take short-term steps to minimise the level of deferred consideration that is payable immediately after completion.?The integration and reorganisation of the target business by the seller might dramatically change its financial profile (for example reduced costs through synergies), and a buyer may wish to have the ability to sell the business during a lengthy earn-out period.?

Typically, an earn-out mechanism will seek to balance these risks by imposing restrictions on the steps the buyer can take during the earn-out period.

Such restrictions might be light touch, including for example the buyer undertaking to operate the target business in “good faith” and/or “in the ordinary course”, or agreeing not to behave with the intention of reducing the level of deferred consideration.

However, some sellers will seek to negotiate and impose detailed and specific requirements on the buyer, including for example that, during the earn-out period, the target business shall not change its name, change board members or amend its key customer contracts.

While the rationale for these provisions is sensible and clear, they create significant scope for disputes.?These provisions often cannot be drafted as absolute obligations and the buyer must be afforded with a degree of discretion.?There is ample opportunity for disagreement as to whether certain business or operational decisions were “reasonable” or in the “ordinary course of business” or taken with “bad faith”.

A seller that is disappointed by the way the buyer has operated or managed the target business post acquisition is likely to wish to interrogate those actions carefully.?Ultimately, the seller may allege that the buyer has breached the contract and claim damages caused as a result.?Earn-outs often do not specify a particular regime for determining conduct of business disputes (unlike the actual calculation of the earn-out, see below), and such a dispute would most likely require determination in court or arbitral proceedings, depending on the parties’ choice of jurisdiction.?If a breach of contract could be established, damages would be calculated to put the seller in the position it would have been in had the contract been properly performed, thus giving rise to complex issues regarding the likely performance of the target business in a counter-factual scenario.?Experience suggests that conduct of business arguments are often used as leverage in the context of a negotiated outcome to the earn-out calculation.

Measure of performance and calculation of consideration

Most earn-out arrangements are based on financial metrics, often profits or turnover of the target business during earn-out period.?Buyers will naturally favour higher thresholds, while sellers should be wary of ‘all or nothing’ situations. As a compromise it is common for a waterfall or sliding scale approach to be used. Such an approach would typically see performance targets split periodically (say each year or each quarter) through the earnout period. Within each period the performance targets would be structured such that, once a minimum threshold is met, the entitlement to the earnout increases incrementally depending on the level of performance over such threshold.

The calculation of the earn-out parameters to be applied can also give rise to disputes. For instance, to what extent should the calculation of the earn-out be insulated from the impact of adverse extraordinary events (such as the impact of the coronavirus related lockdown) or, more generally, force majeure events. There may also be debate over the inclusion or exclusion of ‘windfall profits’, whether or not certain expenses are booked during an earn-out period, the impact of other acquisitions post-completion, and so on. If a possible on-sale is envisaged during the earn-out period, the buyer will also need to be particularly careful that the calculation mechanism for performance targets is structured in a way that can accommodate this.

Whatever benchmark is used, the drafting needs to be as clear and unambiguous as possible and define clearly how the performance will be assessed against the agreed performance metric.?It is crucial that lawyers and accountants are engaged at the outset so that accounting policies and a detailed process for calculation (which should be crafted with a view to minimising subjectivity) can be agreed.

The parties will usually agree a procedure for the determination of the amount of the earn-out payment, often requiring the buyer to produce an account in a specified form to explain the relevant aspects of performance of the business during the earn-out period.?Typically, the seller will then have a particular period of time to consider the calculations and respond.?The parties often provide for disputes to be resolved by expert determination (see below).

Audit rights

At the time the earn-out calculations are undertaken, the seller is unlikely to have access to the books and records of the target business and therefore would not have the means to test the basis of the calculations provided by the buyer.

To address this information imbalance, a seller will often insist on rights to access the books and records of the target business (and sometimes access to employees of the business) in order to audit the process undertaken to calculate the earn-out amount.?Often these rights are drafted restrictively with reference for example to “reasonable requests” for access to books and records.?Again, these provisions give rise to scope for disputes where a buyer is unwilling to allow a seller access to certain categories of sensitive and confidential information.

Taxation

Tax aspects of earn-outs are complex and tax advice should always be taken early, ideally at the heads of terms stage. Stamp duty (applicable to the total consideration for shares, including earn-outs in certain circumstances) and capital gains tax (where proceeds will generally be deemed to comprise any initial payment and the market value of the earn-out at the point of sale) should always be considered to ensure that the full tax impacts of the earn-out mechanism is clearly understood. Further tax issues may arise if any consideration is in non-cash form (such as shares or loan notes). Where the seller is a director or employee of the target it will also be important to consider the rules around employment related securities and circumstances in which consideration may be treated as employment income in the hands of seller.

Dispute resolution

An earn-out mechanism will often provide that if the parties cannot agree the calculation of the earn-out amount, the disputed items should be submitted to an independent expert (usually an accountant) who will make a binding determination on the disputed items.

In most cases this will be an entirely sensible approach.?The purpose of the expert determination is to provide a short-form basis to reach a binding decision by a subject matter expert, which can often be made within a matter of weeks or months, rather than the parties resorting to lengthy and costly judicial or arbitral proceedings.

The process for an expert determination is a creature of the contract and so within the earn-out mechanism, the parties should agree the process that would be followed in the event of dispute.?Important issues will include:

• the procedure for the expert determination, including the way in which the expert will be appointed, the form of submissions (oral or in writing) and the time period within which the determination is to be completed.?The drafting should be sufficiently robust so that one party is not able to drag their feet to grind the process to a halt
• which party bears the burden of proof on a disputed item. Often the onus will be on the seller to persuade the expert that the buyer’s calculation is wrong.?In complex cases where there is no clear ‘right or wrong’ answer, the formulation of the burden of proof may well determine the outcome
• dealing with disputed issues of contractual interpretation.?Disputes often depend on disputed interpretations of the contract.?An expert accountant might be unable or unwilling to make a determination on such issues, but the Courts have made clear that if the contract provides that the expert is to determine issues of contractual interpretation, then that is what it should do.?Consideration should therefore be given to a procedure for the expert to seek advice from a senior lawyer to help it to determine complex legal issues
• that the determination can only be challenged or appealed in the event of fraud or manifest error.?The courts have recently confirmed that the bar for “manifest error” by the expert is high.??It is not just that an expert has reach an incorrect outcome, it must be obviously wrong (or a “howler” as described in a recent Commercial Court decision[1])

Strategic considerations

If the deferred consideration is to be paid in cash, consideration should be given at the drafting stage to the security that a seller might need in respect of amounts that may become payable by the buyer, in light of the counterparty risk.?The outcome of the expert determination is likely to be a contractual obligation to pay, which if breached could be enforced in accordance with the parties’ agreement on applicable jurisdiction (i.e. court or arbitration).?A court judgment or arbitral award against a buyer that does not have the means to pay is unlikely to be helpful.?The best form of security for a seller is likely to be having the cash readily available in an escrow account which can be drawn down upon the determination of the earn-out calculation.?Buyers of course resist this since it undermines the cash flow advantage that might have been a key purpose for the deferred consideration.?Alternative security arrangements or other incentives to pay could be negotiated to provide the seller with some protection.

Parties should also appreciate that the deferral of consideration often creates a dynamic which itself can give rise to further disputes through the interaction with other transaction terms.?For example, a buyer might be incentivised to notify other post-acquisition claims under the SPA (for example claims under warranties, indemnities or restrictive covenants) in order to put the seller under pressure to accept a particular position under an earn-out arrangement.?Sellers should be wary to such approaches and be prepared to defend robustly their position if needed.

Final remarks

The issues above are far from exhaustive, but should highlight that earn-out mechanisms, while extremely useful tools - particularly in the current deal-making environment and for the foreseeable future - are complex and require careful strategic and technical advice from the outset.

For over a decade, we have used our M&A Market Monitor report to monitor and analyse developments in the M&A market, both regarding consideration structures and also other key deal terms. This brings together the collective experience of our specialist M&A lawyers around the world. We continue to monitor closely the emerging effects of the coronavirus pandemic on the structure of M&A deals.

Key contacts

Tim Browning?– Tim is a partner in Eversheds Sutherland's Commercial Dispute Resolution group and ranked as a “key lawyer” in Legal 500. He specialises in high value domestic and cross-border disputes.?His recent experience includes advising on a range of post-M&A disputes, including warranty and indemnity claims, completion accounts disputes, earn-out disputes, restrictive covenant and breach of confidentiality claims.

James Vernon?- James is a legal director in Eversheds Sutherland's Global M&A practice.?He has extensive corporate transaction and advisory experience. His practice covers public company takeovers, private M&A, joint ventures, re-organisations and general corporate advisory work. He has broad sector knowledge and has advised on some of the most complicated and challenging matters in jurisdictions around the world.