Earn-outs: a path through pricing uncertainty after Covid-19 or a highway to litigation hell?
Carlos Pita Cao
European M&A deal activity in 2021 is rebounding after the devastating impact of Covid-19. In the United States, some analysts are already pointing to a shift in payment terms in M&A deals. Prior to Covid-19, 75 per cent cash up front and 25 per cent deferred payment was typical; now. a 50/50 breakdown is expected between cash and deferred payment. A similar trend was seen in the period during and just after the 2008 credit crisis. In our own practice, we are seeing a renewed interest in earn-outs and other deferred payment mechanisms as a way of dealing with pricing uncertainty.
Purchasers are seeking to mitigate risks of further economic downturns and sellers want to avoid being punished by valuations based on short-term Covid-19 impacts. Earn-outs are a tried and tested solution to managing pricing uncertainty. At the same time, earn-outs have been described as converting ‘today's disagreement over price into tomorrow's litigation over the outcome’.
Earn-outs are traditionally seen in two contexts: one, to incentivise founders and management who remain after a change of ownership. In this context, management is rewarded for the achievement of certain business development milestones or revenue/profitability targets. The second context is where a seller and purchaser disagree on the value of the target. The seemingly simple solution is to agree on an earn-out, allowing parties to look back with certainty on an agreed period and to happily share in the actually achieved revenues. Both of these solutions hold within them the seeds of bitter disagreement and skewed incentives.
How is an earn-out clause seen under Dutch law? Dutch law is founded on the principle of contractual freedom and parties are free to agree on whatever earn-out mechanism is appropriate. Contractual provisions are always interpreted within the context of reasonableness and fairness, and what parties reasonably can expect from each other on the basis of the contractual provisions. The so-called Haviltex principles will be applied to determine the parties' intention in agreeing on specific contractual provisions. If parties are professional parties and assisted by legal counsel, then greater weight will be given to the literal grammatical meaning of the contractual provision. These fundamental principles mean that every earn-out clause in a Dutch law-governed contract must be interpreted in the context of the specific negotiation and agreement between the parties.
Dutch case law on earn-outs provides some interesting examples of how an earn-out can go wrong and possibly lead to years of expensive litigation. Take the relatively recent example of Wolters Kluwer. The parties agreed that the sellers would be entitled to an earn-out largely based on the number of new clients signed up during the earn-out period and, for a smaller amount, on the outcome of client satisfaction surveys. During contract negotiations, the sellers argued that they should continue to exercise a sizable degree of control over the business in order to protect the earn-out. Eventually the parties agreed on an undertaking from the buyer that they would prioritise resources and the allocation of employees for the benefit of the earn-out. Ironically, it was the client satisfaction survey part of the earn-out which would lead to the unravelling of the whole earn-out arrangement. The client satisfaction survey showed that the rollout of new client sign-ups without adequate servicing of existing products was a fundamental weakness in the current business strategy. The buyer therefore adopted a new business strategy and changed the allocation of employees, which the sellers argued was a breach of the share purchase agreement. The buyer countered that redirecting resources to increase customer satisfaction would benefit the earn-out. Ultimately, the judge was not willing to adjudicate in summary judgement proceedings on matters which would require factual investigation.
If earn-outs are going to be more common, are there ways in which we can decrease the possibility of disputes? In this article we set out the most important elements of an earn-out clause and suggest ways in which disputes can be avoided by detailed and unambiguous drafting.
Percentage of purchase price attributed to an earn-out
Earn-outs which constitute a significant part of the purchase price are more likely to lead to dispute. A seller who knowingly approaches an earn-out as a possible windfall rather than an important part of the purchase price is far less likely to be disappointed. Significant earn-outs may lead to skewed incentives as one party manages the target company towards maximising the earn-out and the other party has a fundamental interest in minimising the earn-out.
Earn-outs can distract the management from its fundamental objectives, requiring time and effort to be devoted to reporting on earn-out metrics. There is no ‘market’ percentage breakdown between purchase price and earn-out. Ranges of ten per cent to 80 per cent are seen, depending on the industry, the nature of the sellers and the business. M&A advisers may better counsel their clients to compromise on price and agree on a clean break rather than holding out the promise of a lucrative earn-out. In the Buckaroo case, heard in the Dutch Supreme Court in 2007, the potential earn-out was worth more than three times the original purchase price. In that case, management went as far as to fraudulently artificially inflate the relevant earnings before interest, taxes, depreciation, and amortisation (EBITDA) measure. The sellers only discovered the fraud after an unrelated audit exposed emails admitting the fraud.
The American Bar Association’s 2019 deal points survey reports a fairly even allocation between acquisition agreements using revenue (29 per cent) or EBITDA (31 per cent) as the measurement for the achievement of earn-out targets. A further seven per cent used a combination of these two measures. Both measurements have advantages and draw backs. A seller may prefer a straightforward reference to revenue as being less vulnerable to manipulation than a profitability measure in which the allocation of costs may be frontloaded or manipulated. Even purchasers sometimes prefer the simplicity of the measure and the avoiding of endless discussion on whether the earn-out has been triggered or not.
On the other hand, increases in revenue may not represent an increase in profitability if the cost structure has not been managed properly. What is clear is that objective measurements should be sought. Subjective measures such as a customer satisfaction score (which was one of the more surprising elements of the Kluwer earn-out) should be avoided. The following tools could minimise manipulation:
• relying on audited financial statements;
• capping the costs to be applied against the earn-out;
• consider limiting the measurement to a specific product;
• including covenants regarding the consistent application of accounting principles; and
• as a seller, being wary of relying on adopted annual accounts if the purchaser could abuse this by refusing to or delaying the adoption of annual accounts.
Sellers should examine how overhead and indirect costs are allocated against the target's revenue and carve out any one-off costs and provisions that the purchaser may conveniently allocate to the earn-out period, driving down EBITDA. Include illustrative examples of earn-out calculations in the transaction documentation so that parties are on the same page as to how contractual language is translated into line item numbers.
In its 2021 European M&A Study, CMS reported a slight increase in the length of earn-out periods for deals closed in 2020 (17 per cent in 2019 were for 36 months or more; this had increased to 26 per cent in 2020). At least a minimum of 12 months provides a basis for the annual accounts, audited or not, to underpin an earn-out. A period of longer than 36 months is probably unwise given that business strategies may change and make the earn-out an unwelcome constraint or diversion.
Control over business
A key issue in crafting an earn-out clause is to provide for control of the business and thus the ability to influence the outcome of an earn-out. Dutch courts have held that, even in the absence of explicit language, the purchaser must take into account the seller's interest in earn-out. This may explain why, even in transaction documents between professional parties in the Netherlands, there is often no explicit language setting out the obligations of the purchaser towards the seller regarding the achievement of the earn-out.
The recent Wolter Kluwers case gave some additional colour to this obligation of the purchaser. The parties agreed explicitly that the purchaser would prioritise business cases and allocate employees to benefit the earn-out. However, the Court emphasised that the interests of the business as a whole should be leading, although the purchaser should give due weight to the interests of the seller in maximising the earn-out. New circumstances can change this balance and who takes this risk is established on the basis of the agreement between the parties. A court will not sit on the stool of management and management should in principle be free to make decisions for the benefit of the company and its stakeholders.
A seller should, at a minimum, include explicit covenants that the business be run in the ordinary course and that the same accounting principles will continue to be applied. Explicit provisions may also benefit the purchaser. The purchaser has a clear interest in preventing the seller from unreasonably interfering in integration and reorganisation objectives. A purchaser should not agree to unduly burdensome reporting mechanisms. An obligation to report under different accounting principles than are applied in the group as a whole can be expensive and time consuming.
Access to information
In the Buckaroo case, the seller ultimately failed to enforce the earn-out because it had not alerted the purchaser to its concerns within a timeframe which would allow the purchaser to remedy its breach and mitigate the damage.
This may be why the sellers in the Wolter Kluwer case approached the court in summary judgement proceedings. Even though the claim was stranded in summary proceedings, they may still have a second chance as the earn-out period draws to a close to establish a breach. The Grandvision-EssilorLuxotica dispute, dealing with the related issue of an obligation to run the business in the ordinary course, illustrates how far one can go in strategies to obtain information. EssilorLuxotica obtained a court order to seize parts of the business administration, which it argued was necessary in order to establish whether the business was being run in the ordinary course. Certainly, parties should not leave any disputes in relation to an earn-out to the last moment.
Parties often agree to spread an earn-out over a number of years but within those years there is an all-or-nothing payment structure. A more graduated formula providing a percentage payment for partial satisfaction of earn-out targets could lessen the incentives to manipulate data to just reach or avoid the targets, and potentially also lessen the amount in dispute between the parties. A floor and/or cap on earn-out payments can also restrict the range of earn-out payments and lessen the chance of disputes. Parties should consider what the impact of a change of control will be on an earn-out.
Tax and accounting
The procedure for establishing the earn-out amount and managing disputes should be laid out in detail. Consider which party has access to the necessary information and will be in a position to provide an earn-out calculation. Given that disputes are often based on accounting measures, it is common to include a separate specialised dispute resolution mechanism with expert accountants. Specify the impact of tax on an earn-out to avoid any disputes in this regard later. Specialised tax advice will be necessary, particularly if the earn-out is granted to managers who will remain in the business.
Parties should specify whether earn-out payments can be set off against indemnification claims or whether any security will be granted for earn-out payments. In addition, will there be any carry-back or carry-forward of EBITDA or revenue from one year to another?
 Delaware Court of Chancery Airborne Health Inc v Squid Soap LP.
 Rechtbank Amsterdam 2019:8689.
 Vodafone/ECT HR, 19 October 2007.