An earnout is an agreement that promises additional future compensation to the seller of a business if that business achieves specific future financial goals. The seller may be willing to accept a lower sales price at closing if an earnout is included as part of a negotiated transaction.
With the M&A market adjusting to a slowly reviving but still uncertain economy, the rising use of earnout provisions suggests that dealmakers are seeking a shortcut solution to financing challenges that will help close the gap between buyers’ and sellers’ expectations.
Despite intensive due diligence and financial analysis, many buyers may remain uneasy about a target company’s financial performance and profitability post-closing. Earn-out payments can help buyers balance overpaying for the target with a seller’s concern that the business is undervalued. But it’s not all champagne and high-fives; earnouts are often complex deal mechanisms that increasingly result in post-closing disputes. Such provisions can and should be subject to extensive negotiation with trusted counsel.
Although a target’s financial success post-closing benefits both buyers and sellers, sellers will seek to set limits on the buyer’s operation and support of the business during the measurement period, while buyers will want to reserve their right to run the company as they see fit, which is often the inflection point for post-closing disputes.
Take, for example, AI technology company Anduril Industries, which was hit with a breach of contract lawsuit from the founder of Area-I LLC, a company purchased by Anduril in 2021. According to the complaint, Anduril diverted revenue and impaired Area-I’s operations to avoid making more than $15 million in earnout payments.
Area I’s legal action sheds light on the power struggles and conflicts that can arise following corporate acquisitions with earnout provisions. The case highlights the importance of ensuring that both parties involved in a deal benefit equitably from the transaction from the outset.
Dealmakers considering adding earnouts to their agreements would do well to tread carefully to avoid litigation later. Or, at the very least, make sure consideration at closing is enough to “do the deal” even if the earnout is only a modest success – a single or double – but not a home run.
The rise of earnout provisions in dealmaking.
Earnouts are becoming increasingly popular as tools for acquisition finance, especially in private deals. Acquirers have been negotiating earnout provisions into their deal structures more frequently and attribute this trend to difficulties in gaining up-front financing for private transactions. There is a clear upward trend in the inclusion of earnouts in acquisition agreements for transactions worth less than $250 million, increasing from 15.4% in 2020 to 30.2% in 2022.
This is hardly surprising, as the current economic environment has caused deal activity to slump since the first quarter of 2022. Economic uncertainty has created differences in price expectations and insecurity about a business’s performance after closing.
With more earnouts in M&A comes the inescapable flood of earnout disputes. By fixing their parties’ financing and valuation gap problems with this deal device, lawyers are exchanging headaches now for headaches later.
Let’s look at some numbers:
In the first quarter of 2023, 69 earnout disputes were filed in federal and state courts, up from 39 in the first quarter of 2022. In the Delaware Chancery Court alone (the nation’s preeminent forum for determining business disputes), 44 earnout disputes were filed in Q1 of this year. That is four times the 11 earnout disputes filed during the same period in 2022, which on the surface may not seem a lot, but it represents two disputes per business day in the quarter and doesn’t consider those making their way through private channels such as arbitration.
The bigger the earnout (as a percentage of purchase price), the higher the stakes. Transparency around applicable earnout metrics (e.g., revenue, EBITDA), earnout period (typically 1-3 years), payout formula, measurement standard (i.e., GAAP and exceptions to GAAP), and post-closing covenants — are all significant. Any assumptions that are made should be spelled out to avoid future disputes. Clarity is the best protection against future conflicts.
A well-known device to reduce the risk of litigation and encourage settlement is using alternative dispute resolution (ADR) clauses. ADR clauses allow parties to customize their dispute resolution process. Parties can insert the standard arbitration or mediation clause in their contract and can further customize their clause with options that control for time and cost.
However, a recent study on dispute resolution revealed that only 19% of M&A deals in 2022 included ADR clauses. Earnout agreements that invoke ADR often stipulate that the calculation of payment disputes is to be resolved by accountants. But, the scope of this provision could be expanded to cover a broader range of earnout disputes.
For example, in one Delaware state court, case ultimately decided in December 2022, a judge observed that the arbitration provision in the parties’ agreement required an accounting expert to resolve disputes related to the calculation of an earnout amount but not to resolve other disputes arising from the earnout. Since the issue before the court was not about calculating earnout payments but whether earnout targets had been achieved, the court proceeded to hear the case.
Had the parties written a more comprehensive arbitration provision to cover earnout disputes and not just calculations, they could have avoided a trial and resolved their dispute quickly.
If a deal includes an earnout, the parties should:
- Determine the level of obligation required by the buyer to satisfy the trigger.
- Establish how any payout will be financed.
- Anticipate subjective areas that may be open to interpretation or may present opportunities for manipulation.
- Calculate a pro-forma earnout schedule.
- Agree on an appropriate period over which an earnout will be measured and payable.
The use of earnouts would be expected to fall as M&A activity picks up. In a more competitive environment, buyers willing to offer the full price upfront have an edge over buyers requesting an earnout provision. But as a murky economic outlook persists, gaps in valuation expectations will continue to factor in the inclusion of earnout provisions in term sheet negotiations. It’s critical to be prepared and to use experienced counsel to ensure your bases are covered.
We have significant experience negotiating transactions for foreign and domestic US clients. If you need help or have questions, please drop us a line at +1 212 545 8022 or visit our website – www.rooney.law.
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