Earn-out clauses and using an SPA to provide a purely symbolic purchase price

Thursday 21 July 2022

Marco Di Toro
MDT Studio Legale, Torino
mditoro@mdtstudiolegale.it

Giorgia Valenza
MDT Studio Legale, Torino
gvalenza@mdtstudiolegale.it

Collective meaning usually relates M&A transactions to a valuable cash consideration.

However, due to circumstances frequent at the present time and the existing economic situation, a sales and purchase agreement (SPA) could provide a symbolic selling price for a company's share transfer. This generally occurs when the company has a negative asset value that may discourage potential buyers.

These types of agreements may be combined with so-called 'earn-out clauses', also called 'pricing earn-out clauses', to balance the seller and buyer's needs.[1] The use of these causes is increasing in current business practice and allows the transferee of a pecuniary interest to be satisfied, even without a price being paid.[2]

It is undeniable that this type of clause plays an important role in helping the seller and buyer to reach a common point of interest regarding purchase price determination, especially when the consideration for the seller has been agreed to be purely symbolic.

The Italian Court of Rome recently dealt with this topic in an award issued on 13 November 2020 (the 'Court of Rome Case'). A brief examination of the aforementioned clauses is necessary before commenting on the Court of Rome Case.

Earn-out clauses

Earn-out clauses are atypical clauses that provide that a part of the price negotiated between the parties will be paid by the purchaser after 'closing' only if the target company achieves certain performance goals or activities.[3]

Two expressions of these clauses are commonly distinguished:

  • 'performance earn-out clauses' focused on the achievement of certain business goals in the period following closing (eg, increase in sales, number of customers and investments);[4] and
  • 'economic earn-out clauses', which provide that, for a specific period of time, the seller will receive part of the profits earned by the target in the specific period following closing.[5]

Another possible scenario is that the target decreases its performance; therefore, 'reverse earn-out clauses'[6] also exist, which are provided for the buyer's interest: 'these clauses lead to a reduction of prices if the target company, in the period following the acquisition, does not achieve certain economic or commercial objectives agreed and identified in the contract that the contractors gave as reasonably certain at the time of signing the acquisition contract and on the basis of which they had agreed the transfer price'.[7]

As a general understanding of earn-out clauses allows the capture of the dynamic business flow of the target company, they consider the different scenarios of the expansion or contraction of the business, which might affect the increase or decrease of the value of the target over time.[8]

However, it has been, correctly, noted that these clauses do not represent a guarantee by the seller of the company's profitability, rather a way of determining its fair price.[9]

Italian case law generally recognises these types of clauses as fully valid because they normally comply with requirements set by Italian law. To understand the underlying motivation of this recognition, it is worth considering the most relevant Italian Civil Code rules that affect 'earn-out' clauses.

First, Article 1346 of the Civil Code requires that the object (oggetto) of a contract must be determined or determinable in order to be considered valid           .

As previously mentioned, earn-out clauses apply to a business and or shares/stake SAPs. Hence, these clauses are valid, provided they clearly state the amount to be paid by the purchaser (or by the seller in the case) or the relevant determination criteria. Instead, they are null and void every time they do not allow the accurate quantification of the relevant amount of the increase or decrease of the price.[10]

Another important aspect concerns the provision in Article 1355 of the Civil Code, which states that:

'the transfer of a right subject to a condition that depends on the mere will of the Seller or the Purchaser is void'.

A condition is considered to be merely potestative (ie, 'mere will') when the conditioning event consists of a voluntary act whose performance depends on the 'mere will' of the party.[11]

In fact, earn-out clauses involve the buyer paying the part of the purchase price whose value could depend on the buyer itself[12] 'because after the acquisition, the buyer will be actively involved in target company management inevitably affecting the acquired company performances. This might sound like a sort of "mere will".'

Therefore, to avoid potentially invalidating this class of clause, it is necessary to verify, on a case-by-case basis, that the specific situation, that is, triggering the earn-out clause, complies with Article 1355 of the Civil Code.

Purely symbolic purchase price

Italian case law has always paid attention to all cases in which the share transfer price is symbolic or equals zero because the law provides that any sale and purchase, and any contract that implies the transfer of something must be linked to the payment of a price or other 'economic consideration'.

Thus, if the price is purely symbolic, it might be considered to be non-existent and therefore, the relevant contact would lack one of its fundamental requirements: the 'purpose' (la 'causa').

The Court of Rome Case

In light of the aforementioned observations, it is possible to appreciate the Court of Rome Case.

The case concerns the transfer of the shares of a negative value business at a purely symbolic price (€1), while providing for an earn-out clause to increase the sale price. First, the Court of Rome declared the legitimacy of a symbolic sale price if the parties have an economic interest to execute the transaction.

The Court of Rome Case assessed that a zero price sale can still achieve the seller's legal and economic interest[13] and therefore, the 'causa' exists.

Second, the Court of Rome also confirmed the full validity of earn-out clauses according to the prevailing opinion. In particular, the judges stated that 'the earn-out clause which provides for the integration of the sale price of the shares on the basis of any assets resulting from the final liquidation financial statement of the company, to be prepared following completion of the deed of sale, is valid and effective'.

Later, the Court of Rome focused on the possibility of the clause being a 'merely potestative' condition precedent. On this topic, the Roman judge considered that the price integration mechanism identified did not depend on the pure discretion of the buyer.

Earn-out clauses: the solution to break the economic deadlock

It cannot be denied that these clauses might be used as a solution to a significant deadlock economic situation in a possible deal, for example, those negotiated during the Covid-19 pandemic.[14]

Obviously, in this framework, both the seller and buyer could be sceptical of entering into an M&A transaction with staggered values. Indeed, on the one hand, the buyer could be afraid to complete the acquisition of a company with a critical asset structure. On the other hand, sellers were not willing to sell their companies whose values had been reduced due to the pandemic.[15]

In fact, earn-out clauses offer, for example, the possibility to solve any deadlock linked to the uncertainty of the value of a company, especially due to exceptional circumstances, and allow a prospective seller and buyer to test the value of the business and sign a mutually fair deal.

 

[1] A Scorzolini, La clausola di earn-out, 7 February 2018 www.iusinitinere.it/la-clausola-earn-out-7751 accessed 7 July 2022.

[2] N De Luca and F Schiavottiello, Cessione di partecipazioni a prezzo simbolico e clausola di earn-out, in riv Le Società, 11/2021, IPSOA, Assago, p 1214.

[3] S Cirino Pomicino, Clausole di Earn Out, in Clausole Negoziali di M Confortini, Utet Giuridica, 2017, Milano, p 989.

[4] M Cavallo and F Quatrini, Earn-out clauses: advantages and pitfalls, 28 March 2012, https://portolano.it/en/news/earn-out-clauses-advantages-and-pitfalls accessed 7 July 2022.

[5] G Cabras and C F Luzzi, Dizionario a cura di Giovanni Cabras e Concetta Brescia Morra, 09.2003 wwww.dircomm.it accessed 7 July 2022.

[6] L Miele, Compravendita di aziende e di partecipazioni sociali: le clausole di rettifica del prezzo, Corriere Tributario, n 38/2014.

[7] M Bianchi, M&A - Le clausole di earn-out nei contratti di acquisizione societaria – SPA – Sales and Purchase agreement, Aprile 2021 www.contrattiinternazionalidimarcobianchi.it accessed 7 July 2022.

[8] G Politelli, Valutazione prospettica della cessione di azienda con clausole 'earn out' e 'clawback', 24 January 2020 www.quotidianogiuridico.it accessed 7 July 2022.

[9] See n 2 above, p 1215.

[10] R Caso, Clausola Earn out? Valida con le dovute attenzioni, 20 July 2021 www.ldp-ita.com accessed 7 July 2022.

[11] Cass civ, Sez III, Sent, (data ud 20/05/2014) 26/08/2014, n 18239.

[12] G De Nova, Il Sales and Purchase Agreement: un contratto commentato, Giappichelli, Torino, 2009, p 146.

[13] M Meoli, Nella cessione di partecipazioni il prezzo può essere integrato. Valide le clausole di earn out che rimettono la determinazione del prezzo a un momento successivo, 26 May 2021 www.vptl.it accessed 7 July 2022.

[14] F Cartolano, Le clausole di earn out, 13 April 2020 https://afge.legal accessed 7 July 2022.

[15] C Karen, Hermann Charles, J Morton, Jr and Scott Rissmiller, COVID-19 Pandemic Impact on M&A: Earn-Outs – The Basics and Key Issues, 19 June 2020 www.venable.com accessed 7 July 2022.