Divider
Divider

Allen Liebnick
Allen Liebnick

Earnouts Often Result in Disputes

How to avoid and/or mitigate the risk of earnout disagreements.

July 7, 2011
by Allen Liebnick, CPA, CFF

In last month’s column, Attorney-at-Law and Partner with the Texas-based law firm Looper Reed & McGraw, Mark Wigder, explained the applicability of earnouts in a sales and/or purchase arrangement. Wigder is well versed in earnouts since his firm focuses on corporate and securities law, mergers and acquisitions, public offerings, private placements, financings, SEC compliance and corporate governance as well as what earnouts are and, among other things, various points to consider in negotiating the earnout. Earnouts often result in litigation. As Vice Chancellor Travis Laster of the Delaware Chancery Court observed in the Airborne Health case: “[A]n earn-out often converts today’s disagreement over price into tomorrow’s litigation over outcome.” This article will address the common areas of disputes with respect to earnouts and how to avoid and/or mitigate the risk of earnout disagreements.

The Most Common Types of Earnout Disputes

  • Earnout Calculation. According to Wigder, measuring benchmarks and what expenses, assets or revenue sources should be included or excluded are the most common earnouts. Earnouts can be extremely technical and complicated calculations and therefore disputes often arise with respect to the earnout calculations because the earnout provisions were not drafted with clarity. Earnout provisions highlight the challenge of attempting to draft an earnout provision that sets forth complex accounting principles clearly and yet covers all eventualities. Recent cases have included whether revenues from certain products should be taken into account in the earnout, whether corporate overhead charges should be allocated to the seller, whether certain expenses should be characterized as one-time (and, therefore, excluded from the amount calculated) or on-going and how to account for revenue that spans multiple years of the earnout period.
  • Management and Control. This begets the question: “Is buyer or seller responsible for the Operations Germane to the earnout during the earnout period?” asked Wigder. Following the consummation of the acquisition, the buyer will have legal ownership of the company, but will need to allow the seller to retain some control over the operations during the earnout period. Seller’s control, if any, has to be embodied in the operating covenants set forth in the acquisition agreement.
  • Implied Covenants in Earnouts: Good Faith, Fair Dealing and Reasonable Effort. For example, in Sonoran Scanners, Inc. v. Perkinelmer, Inc., 585 F.3d 535, 543–44 (1st Cir. 2005), the First Circuit applied Massachusetts law and held that the buyer must expend reasonable efforts to promote and develop seller’s products in order to achieve the earnout payout even in the absence of an express provision. In Airborne Health, Inc. v. Squid Soap, LP, 984 A.2d 126, 145-46 (Del Ch. 2009), the court recognized the implied covenant of good faith and fair dealing in the context of an earnout agreement, but held for the buyer, finding that such implied duties do not apply because the buyer’s duties were expressly provided for in the agreement.

How to Avoid and Mitigate Earnout Disputes

Wigder pointed out that failure to draft earnout provisions and address all potential facts and scenarios that may arise carefully can often lead to litigation. He also said that “courts have been reluctant to intercede on the seller’s behalf in the absence of specific protections in the acquisition agreement or employment agreement. Thus, it is critical that sellers are proactive about protecting their rights during negotiations of the earnout rather than waiting for litigation.”

Clear and Exhaustive Contract Terms. Most earnout disputes boil down to different interpretations of the earnout agreement. By planning ahead and making decisions upfront, parties to earnout agreements may be able to avoid future litigation over potential ambiguities. Important terms to consider are:

  • Selecting an earnout benchmark that is easier to calculate. If the chosen benchmark is gross earnings, potential disputes over what expenses to include are eliminated. Although Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) requires a more difficult calculation, it is often a better reflection of company performance as gross earnings overstates actual profit. Best practices call for the preparation of a detailed calculation of the earnout that should be incorporated into the acquisition agreement to ensure that there will not be a dispute regarding the earnout calculation post-closing.
  • A clear statement regarding which entity or persons can make management and control decisions that affect operations of the acquired business during the earnout period. Key management personnel of the seller should have employment agreements with the buyer to ensure that they cannot be terminated during the earnout period without cause. The buyer should be restricted from changing accounting principles applicable to the calculation of the earnout and from rolling other entities into the seller. The buyer and seller should keep separate financial records during the earnout period.
  • An explicit statement of buyer’s duties in the purchase agreement to act in good faith or use reasonable efforts.

Selecting a Favorable Law to Govern the Agreement. Parties should aim to select a governing law in the agreement that is most likely to produce a favorable outcome should the earnout agreement come to litigation, as well as the jurisdiction to hear such litigation. A favorable governing law, as well as a favorable venue, is of particular importance in
cross–border acquisitions.

Including a Liquidated Damages Clause or Other Remedies. In certain circumstances, courts have found earnout damages are too speculative even if a court finds that a buyer has breached the earnout agreement resulting in an award of nominal damages. Therefore, the parties should consider including a liquidated damages clause. From the seller’s perspective, the seller should argue for a provision that accelerates the earnout payments (i.e. similar to a promissory note) to the seller if the buyer breaches the earnout agreement or employment agreement of the seller’s management, including terminating members of such management without cause.

Including Dispute Resolution Mechanisms in the Acquisition Agreement. The acquisition agreement should include provisions on how to settle earnout disputes in the event that they arise. Most acquisition agreements include an arbitration clause.

Conclusion

By being cautious and taking these precautionary steps, both buyers and sellers can avoid unnecessary headaches over possible litigations.

Rate this article 5 (excellent) to 1 (poor). Send your responses here.

Allen M. Liebnick, CPA, CFF, is president of Overpaid Payables Recovery, Inc.. He has been providing accounts payable, sales tax and telecommunications post-audit recovery services for over 18 years. Liebnick is a member of the New York State Society of CPAs as well as Texas Society of Certified Public Accountants and chair of the 2011 Texas State Society of CPAs State Tax Conference. Liebnick thanks Mark Wigder for his contribution to this article.