The well-documented problem is that the earnout bridge that parties take to bridge their valuation differences often leads to disputes as to whether the earnout has been respected or why it has not been respected. [1] Two recent decisions of the Complex Commercial Litigation Division of the Delaware Superior Court show how careful drafting affects the risk of litigation that results. Trends in Earnout Regulation Since 2005, the ABA has published its Private Target Mergers and Acquisitions Deal Point Studies (ABA Studies) every two years. ABA studies examine contracts for the purchase of publicly available transactions in which private companies are involved. These transactions vary in size, but are generally considered to be in the middle market for M&A transactions; The median value of transactions in the 2019 study was $145 million. If you are the seller, some of the most important provisions to negotiate focus on the operational control of the company during the earn-out period. If the purchase price is based on the realization of the net profit or EBITDA benchmarks, you need to control the variables that affect the income statement. Define the seller`s rights in the purchase agreement or in the operating/shareholder agreement. Obtain in writing the buyer`s commitment to leave the transactions largely unchanged during the earn-out period.
If the buyer insists on investments or expenses that are outside the historical level, try to negotiate that these selected expenses are additions to the calculation of net income or EBITDA. In a lawsuit alleging, among other things, non-compliance with the earnout agreement, the seller asserted claims for breach of contract, non-implied claims. Unlike Collab9, the court rejected the buyer`s request to reject some of the seller`s earnout claims, focusing on the first and third obligations of the earnout agreement. The 2019 ABA private target Mergers and Acquisitions Deal Points study shows that buyers, at least in the available data, „win“ these negotiations when they take place. Of the subset of offerings that include earnouts, only about 30% include a commitment to run the business in accordance with past practice or maximize earnout. Finally, more than half of earnouts in stunned studies included a compensation accounting right. Most sellers feel that their businesses are worth more than they are. Provisions for earn-out can bridge the valuation gap between an optimistic seller and a skeptical buyer.
This allows the company to prove itself. Approximately 60% to 70% of earnout provisions examined in the aba studies used EBITDA or revenue as the most important earnout measure. In Collab9, LLC vs. En Pointe Techs. Sales, LLC[2], one seller argued that the implied good faith and fair trade agreement requires the buyer to maximize an earnout provision in an asset purchase agreement (APA). The seller asserted that the buyer breached its duty of good faith and fair trade by „keeping financial records in a manner that made it impossible to accurately determine the exact amounts of earn-out payments; the creation of a fake unit to derive income from [their] books; and the renewal of certain contracts or the transfer of sales representatives or accounts as a means of minimizing adjusted gross margin. [3] With respect to the third obligation of the earnout agreement, the buyer argued that the seller could not claim damages resulting from the buyer`s decision to build an alternative bridge between the parties` systems. Relying primarily on Delaware`s minimum standard for damages claims – which does not require „damages with precision or specificity“ – the court concluded that it was reasonable to conclude from the agreement that a specific solution was necessary to provide services to customers and calculate the amount of the earnout, as well as the lack of construction of that solution.
could constitute damage. [14] Based on our experience in creating exit plans and facilitating M&A transactions for over 125 agencies (sell-side and buy-side representation), here are 12 earn-out elements and what we believe to be the best practices in designing and negotiating terms and conditions. Depending on the circumstances, the purchaser may be required to recognize the fair value of the earnout at the balance sheet date in accordance with GAAP. In addition, parties often use earnouts to retain selling shareholders as key employees for a period of time after closing. However, if the payments are employment-related, for example. B if earnout payments are not made, if a selling shareholder is no longer a target employee on the payment date, the payment may be considered as compensation instead of the purchase price, which may affect both the buyer and the seller. Earnouts are often used to bridge price differences between buyer and seller. For example, the seller wants $100 for their business, but the buyer is only willing to pay $75 at closing. However, the buyer is willing to pay an additional $25 after closing if certain milestones are reached after closing. Under otherwise equal conditions, the conditional nature of the earnout payment is not as favorable to the seller as cash at closing, and the buyer`s level of control over the business during the earnout period may add to this concern. On the other hand, buyers often like earnouts because they deter some purchase price risk.
This position is especially true if the target is a start-up company or has unproven products or business models. With respect to the first obligation of the earnout agreement, the court held that the provision was a negative agreement that obliges the buyer to refrain from „positive measures“ that could reasonably be expected to reduce the earnout or impede the calculation of the earnout. However, that obligation did not extend to `avoidance of inaction`, since the extension of that obligation `would place the power to manage the company in the hands of the seller`. [11] In analyzing the specific allegations in the complaint, the Court concluded that many of them were not in a position to seek affirmative action. These allegations related to „decisions and strategies[that [the buyer] could have pursued, but did not pursue,“ such as . B consult the seller about marketing. [12] The lawsuits that survived the rejection request focused on positive actions such as „systematically removing regular calls to prevent [the seller] from promoting and selling the products,“ and inappropriate accounting decisions regarding minimum billing thresholds and redirecting revenue to other products to avoid paying earnout. [13] Buyers tend not to agree to operate the target business after closing in accordance with past practice or to take steps to maximize earnout. These commitments are observed in 30% fewer reported transactions, as shown in the graph below. Unlike many aspects of a M&A purchase agreement that have been fairly standardized with established market parameters and formulation agreements, earnout provisions are very fact-specific and often heavily negotiated. Therefore, there is no typical earnout determination.
However, some fundamental considerations play a role in determining and negotiating an appropriate earnout provision. Conclusion Earnout provisions are often highly negotiated and fact-specific. As a result, their inclusion in M&A purchase agreements is the exception rather than the rule. As part of the purchase price, a provision for earnout reflects the actual dollars of the buyer and seller. Therefore, lawyers who trade earnouts on behalf of their clients should pay close attention to the various earnout issues and options. Sellers, of course, don`t want to wait until the end of an earn-out period to receive all their money, so most deals include money at closing, as well as interim payments made annually or quarterly. Interim payments may be subject to buyer protection terms. At the end of the earn-out period, when the total purchase price is determined, the final or „truthful“ payment will be equal to the calculated purchase price minus cash at closing and minus interim payments. The milestones that, when reached, trigger the payment of an earnout must be clearly defined in the purchase contract. These are often financial milestones, such as reaching a certain level of EBITDA within a prescribed period of time, but they can also be non-financial, such as.
B obtaining a major regulatory or regulatory approval or a contract in preparation or entering into a major strategic partnership. One question related to reaching milestones is whether earnout should accelerate in the event of a change of control. In addition, earnouts below a quarter of reported earnouts explicitly accelerated towards a change of control. If the seller`s initial payment date depends on future performance, the seller should consider incentives for turnkey employees who follow the earn-out plan`s performance indicators. This can be achieved via Phantom Stock plans or stay bonus plans. With the Phantom plan, some employees can earn a percentage of the purchase price when paid to the seller, as long as they remain employed. .