Introduction
The global merger and acquisition (M&A) market has been hit by a number of challenges in recent times, including significant geopolitical and general financial challenges, rising interest rates and global supply chain uncertainty. In response to these destabilising factors, the key focus for prospective purchasers in private treaty M&A transactions has been exercising caution and using flexible arrangements to reduce both completion and down-side risk.
Once a purchaser identifies a suitable acquisition target or, in the case of a seller, receives genuine interest from a prospective purchaser, often one of the key barriers to progression of negotiating and completing a successful M&A transaction is a disparity in the parties’ expectations of the value of the target asset(s) or business (Target). In this regard, there are measures that can be used to ‘bridge the valuation gap’ between the purchaser’s and seller’s expectations on what the Target is worth.
One common way that parties may seek to overcome the ‘valuation gap’ is by using an earnout mechanism, which is essentially a form of deferred consideration, which is contingent on the Target performing as the purchaser expects it to perform for a certain period of time after completion occurs.
What is an earnout arrangement?
Earnout arrangements are a form of deferred consideration where at least part of the purchase price for a Target is not paid on completion but, rather, is calculated based on a specified metric of the performance of the Target following completion.
An earnout provides an effective solution to purchasers and sellers who may have divergent views on the value of the Target. Earnouts allow a purchaser and seller to overcome a potential impasse on negotiations over pricing, particularly in circumstances where:
- the financial performance of a Target has been adversely affected, perhaps only temporarily, by circumstances such as short-term staff shortage or a supply chain disruption; or
- the Target is still in the relatively early stages of its life-cycle or operates in a dynamic or fast-moving sector.
More often than not, an earnout arrangement will involve the key person(s), or seller(s), of the Target remaining involved in the operations of the Target for a period of time following completion with a view to increasing the likelihood of the Target continuing to run smoothly during the transition period of ownership and for an agreed period after completion.
Importantly, from a purchaser’s perspective, an earnout arrangement provides a basis on which to ensure that the ultimate purchase price is based partly on the ongoing performance of the Target following completion, rather than relying purely on what the seller has represented to the purchaser as the historic performance of the Target.
Earnout structures and measures
When negotiating and drafting earnout mechanisms, the key considerations that should be taken into account are:
- the duration of the earnout period;
- how the Target’s performance will be measured over the earnout period, and how the earnout amount will be calculated;
- the extent to which the seller will continue to be involved in the Target following completion;
- if any disputes arise in relation to the earnout calculation, how they will be resolved; and
- whether the purchaser’s post-completion conduct should be restricted or limited in any way that might affect the performance of the Target or the earnout amount.
When structuring earnout arrangements, one very important element that needs to be considered carefully is the specific metric that is used to measure the performance of the Target. The metric may point to a specific financial performance indicator such as revenue or profit, or it can be a formula that uses a combination of different indicators.
In 2020-2021, the most common metric for earnout arrangements was revenue (which accounted for approximately 30% of all earnout arrangements), followed by EBITDA (which accounted for approximately 20% of all earnout arrangements).1 However, a specific metric or formula that may be appropriate for one Target may not be suitable for another. The earnout calculation must be specifically customised and formulated (generally with input from accounting and/or financial advisors) depending on the individual business, the industry in which the Target operates, as well as the commercial goals of the parties.
Common areas for dispute
Due to the fact that earnout calculations often differ from one transaction to another, there is a lack of ‘standard form’ earnout provision. Accordingly, it is not surprising that disputes often arise between a purchaser and seller in the context of earnout provisions.
Amongst these, the calculation of the financial indicator from which the earnout figure is derived from is the most commonly disputed issue. As set out above, EBITDA and revenue are the two most common performance indicators to be chosen to form the basis of earnout calculations, which measure profitability and sales respectively.
It is important to note that, although the parties are free to choose any financial indicator or formula to calculate the earnout component of the purchase price, the more complex the character of the financial indicator chosen, the greater the risk for disputes to arise when it comes time to calculate and agree on the earnout figure.
An earnout figure based upon a calculation of the profitability of the Target (such as EBIT and EBITDA) is often a highly desirable choice for parties when entering into the sale transaction. However, the calculation of profitability, even where there is an agreed formula in the earnout provisions, gives rise to a number of areas for potential dispute, given that it includes calculations of sales, inventories, and appropriation of costs, such as overheads. Further, the proper application of accounting policies may also become the subject of dispute.
In contrast, the use of sales (such as gross sales and revenue) as a basis for earnout calculation is a far simpler method of calculation, however it is not completely immune from disputes, as outlined in some of the scenarios below.
It is not difficult to see that there is a tension between seller and buyer when it comes time to interpret what the earnout provisions may mean and to calculate the earnout figure. Earnout regimes exist only as part of an overall sale transaction. The sale transaction obviously involves a change in ownership of the Target from the seller, who previously controlled and managed the Target and who has the benefit of the earnout clause, to the purchaser who now has the management and control of the Target. Typically, post-completion, the purchaser may wish to effect certain changes to the business and will often introduce new systems and procedures which the purchaser believes will benefit the Target.
Where those changes cause an impact on earnout calculations, disputes between the purchaser and the seller may arise.
The following examples illustrate some of the common sources of disputes that arise in relation to earnouts:
- Changes in accounting systems. Where the purchaser implements a new accounting system in the acquired Target (which may be due to achieving consistency with the purchaser’s other businesses), the change may lead to a variation in calculation of certain financial figures. The issue may be worsened by lack of staff training or an ineffective rollout process.
- Changes in cashflow protocol. Where there is a change in cashflow protocols, any difference in this regard between the pre-completion period and earnout period may lead to a dispute regarding the earnout figure.
- Diversion of resources to manage the business. Often, certain issues in the Target, such as regulatory issues, only surface post-completion which in turn need to be addressed by the purchaser’s management and their staff. The diversion of resources to deal with such issues which could otherwise be used by the business often has a negative effect on the earnout figure.
- Interpretation of earnout provisions in the contract. When it comes to the time of calculation, the parties may realise that the drafting of the earnout provisions do not contemplate certain scenarios which arose during the earnout period, or the parties discover that each other operated on different assumptions that had not been expressly set out.
- Breakdown in communication. Disputes sometimes arise where the seller has failed to raise with the purchaser, the seller’s concerns regarding the manner in which the business is being run during the earnout period, but instead raises such issues after the earnout period has concluded.
Case study
The case study below illustrates some of the issues and complexities of disputes regarding earnout provisions.
In Metalicus Pty Ltd v Metwholesale Pty Ltd [2011] VSC 2, the parties entered into a contract for the sale and purchase of two clothing businesses. Part of the earnout amount was to be calculated based on the EBITDA over a financial year which included the earnout period. In calculating the earnout amount, various conflicts arose between the parties in relation to the financials and the conduct of the business during the earnout period. One of the main conflicts between the parties related to the expenditure that was to be taken into account in assessing the earnings (and therefore, the EBITDA) of the business. Not surprisingly, it was in the purchaser’s interest for every dollar spent by the business to be considered when calculating the earnings of the business, whereas it was in the seller’s interest for only usual and ordinary business expenses to be regarded when calculating the same figure.
The contract provided that, in the earnout period, the business was to be “conducted in accordance with the 2008 Budget”, as well as “in a manner consistent with how the business has been conducted by the vendors in the 12 months preceding the completion date”. The seller argued that the purchaser, in conducting the business, must strictly follow each line item provided in the 2008 Budget, whereas the purchaser argued that the earnout clauses read as a whole would only require the purchaser to conduct the business having regard to the 2008 Budget.
The Supreme Court of Victoria ruled in favour of the purchaser, based on the fact that to interpret the earnout clauses as requiring strict compliance by the purchaser would have been not only impracticable but impossible. This was because the budget did not make allowance for certain expenses and costs, and as such to require a strict compliance with the budget may cause the purchaser to breach its obligation to conduct the business in a manner that is consistent with the period leading up to completion. In coming to this decision, the Court had regard to what would have been the parties’ intentions at the time that the contract was formed.
Therefore, earnout clauses must be drafted as specifically as possible. When formulating earnout calculation, it may also be worthwhile to carefully consider whether strict compliance of the earnout clauses is at all achievable or the relevant clauses may potentially be construed by the Court in a manner adverse to one of the parties or ultimately considered unenforceable.
Practice and drafting tips
Earnout clauses should be drafted and negotiated in clear, unambiguous terms and should be as specific as possible. Some practical tips to minimise disputes from arising include:
- providing worked examples in the contract to illustrate how earnout is calculated;
- clearly setting out the accounting standards upon which the calculations are based;
- clearly setting out the assumptions underpinning the calculations of the key financial performance indicators;
- clearly articulating the sellers’ and the purchasers’ expectations on how the business is conducted during the earnout period; and
- providing a suitable dispute resolution process in the contract in order to deal with any disputes that may arise in connection with the earnout.
Earnout mechanisms can be a powerful tool to help the seller and the purchaser to come to an agreement to an acquisition price. However, care must be taken to prepare the transaction documents to avoid disagreements between the parties during and after the earnout period.
If you require assistance in negotiating, drafting and reviewing your sale and purchase contract, HWL Ebsworth Lawyers is here to help.
This article was written by Ashley Holland, Partner, Tom Morgan, Partner and Stella Lee, Special Counsel.
1Matthew Nelson, The Australian M&A Playbook 2022, HWL Ebsworth Lawyers (Report, 28 March 2022).
