Dispute Resolution | Private Equity
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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.
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.
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.
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 other things that can really help mitigate disputes, or lead to them being resolved more quickly are:
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.