When earn-outs go wrong: a troubleshooting guide  

Welcome to the second part of our series on disputes trends we have seen on the rise. In our first article, we explored the circumstances in which a buyer and seller may wish to use an earn-out mechanism, as well as how this can be structured.

In this article, we turn to look at the steps that parties can take to prevent earn-out disputes arising, as well as how to best resolve a dispute if one does arise.

What is an earn-out?

An earn-out is a term used to describe a deal mechanism which allows the purchase price of a target company to be determined by reference to its future performance.

Earn-out mechanisms can be a useful tool in circumstances where parties are unable to agree on a fixed purchase price, or where a buyer requires a level of continuing involvement from the seller's management. We are experiencing a rise in disputes as a result of tougher than expected economic and trading conditions, and – sometimes - poor drafting or not enough thought by the parties.

Avoiding disputes

A clear and well-drafted share purchase agreement (SPA) is key to avoiding disputes.

The terms of the SPA should, amongst other things, ensure that there is a clearly defined performance milestone and methodology for calculating the earn-out payment, as well as a clearly defined earn-out period, ie. the period of time for which the company's performance is to be considered for the purposes of any calculation.

The best SPAs also provide for a dispute resolution mechanism for arguments that inevitably arise when e.g., EBITDA is harder to earn than expected and the two parties have differing expectations around triggers being hit and payment.

The parties should also make sure that the acquisition makes sense. Does the target company 'fit in' with the buyer's acquisition strategy? Are stakeholders, including employees and any key management which the buyer intends to retain, onboard with the buyer's vision and objectives for the target company?

All these factors have the potential to affect the future performance of the target company, and therefore the potential to affect the earn-out payment. These considerations will also be key to ensuring a smooth transition of the target company into the buyer's wider group.

For further consideration of the practical steps that parties can take to avoid earn-out disputes arising, see our previous article.

Resolving disputes

Though the parties can mitigate the risk of earn-out disputes arising by taking the steps outlined above, unforeseen circumstances (such as the COVID-19 pandemic) can nevertheless cause disagreement. This is particularly the case where an unforeseen event causes an earn-out mechanism to behave differently to the way in which it was envisaged to behave by the parties at the point of negotiation and have an unintended effect.

It also happens where the mechanism worked as expected but unanticipated headwinds hit the company and hitting payment triggers becomes harder than expected or impossible. It is therefore important that the provisions of the SPA set out a clear dispute resolution procedure.

We set out below an example of a typical procedure which can be followed in the event of an earn-out dispute arising.

• The buyer will, by a date agreed between the parties, deliver to the seller a copy of the relevant reference accounts as well as an earn-out statement setting out its calculations and any adjustments which have been made.

• Within an agreed number of days following receipt of the reference accounts and earn-out statement, the seller will deliver a notice to the buyer indicating whether it agrees with the contents of the earn-out statement and calculation of the earn-out payment. If the seller disagrees, it should serve an objection notice upon the buyer which sets out in sufficient detail the issues which it disputes.

• Upon receipt of an objection notice, the parties will attempt in good faith to resolve the matter between themselves. If, however, the dispute is not resolved within an agreed timeframe, either party may serve a resolution notice requiring the dispute to be referred for expert determination. If possible, the expert should be jointly selected by the parties, however, if the parties are unable to reach agreement the SPA should nominate an independent third body to appoint an expert on the parties' behalf.

• The scope of the expert's jurisdiction should be clearly defined within the SPA and limited to the issues in dispute that are within the expert's expertise.

The other things that can really help mitigate disputes, or lead to them being resolved more quickly are:

1. Actually complying with whatever mechanism the SPA contains – for instance the preparation of regular Management Information or a periodic Earn-Out Statement.
2. As a related point, a culture of no surprises between the buyer and the sellers/recipients of the earn-out about things like EBITDA performance, the impact of integration of the previous separate business unit post acquisition (which is very often the whole point of the deal), and unexpected events relevant to revenue/earn-out calculations so these get aired early and the parties' expectations about payments are not way out of alignment.

In summary

There are a number of steps that a seller and buyer can take to mitigate against the risk of earn-out disputes arising. However, despite all best intentions of the parties, these steps might not always be successful in helping avoid future disagreement. As such, the parties should ensure that any SPA which is entered into contains an effective dispute resolution procedure and start to air potential areas of disagreement well in advance of expected payment dates.

If you would like to discuss any of the issues explored in this article in more detail, please contact a member of our team.