Page 42 - M & A Disputes

Chapter 3

Earnout Provisions and Disputes

Introduction

Some acquisition agreements contain a provision that requires a buyer to pay additional consideration to
a seller subsequent to the closing date if a target company meets certain contractually defined bench-
marks. These provisions are commonly referred to as an earnout adjustment.

For example, a buyer agrees to purchase a business that sells widgets; however, the buyer is concerned
that, due to changing market conditions, the demand for widgets will decrease substantially after the ac-
quisition. As a result, the buyer and seller agree that if more than X number of widgets are sold during
each of the next two years, the buyer will pay the seller additional money.

An earnout provision is typically used when the buyer and seller cannot agree on the future prospects of
the target or when the buyer and seller cannot agree on a reasonable basis to estimate the future pro-
spects of the target. In other words, the earnout adjustment allows the seller and buyer to compromise on
what they feel the target is worth. An earnout provision is also used to motivate a principal seller’s in-
volvement after acquisition when a target’s operational growth depends on the talent of the principal
seller. For example, the following situations may be candidates for using an earnout provision in an ac-
quisition agreement:

 The sale of businesses that are newer, smaller, and more volatile in its growth prospects.

 A seller projects increasing growth on a go-forward basis, but a buyer projects a smaller growth
rate.

 A seller made recent changes to the operation, such as a restructuring, and believes that it will re-
sult in a substantially more profitable business.

 A seller has a new product with substantial growth expectations, and the buyer perceives those
expectations as unproven.

 A buyer is skeptical that reported historical earnings of a target are a reflection of the target’s
true profitability.

Although an earnout adjustment can be a useful mechanism to help buyers and sellers agree on price,
earnout adjustments often become the subject of dispute subsequent to closing. This chapter discusses
the mechanics of earnout adjustments and common issues and considerations that relate to postclosing
earnout disputes. Practitioners typically possess the skills, knowledge, experience, and training to help
buyers and sellers avoid earnout adjustment disputes and to resolve them if they arise. In this regard, the
practitioner can serve as either a consultant or a neutral arbitrator or mediator.

Mechanics of Earnout Adjustments

The contractually defined benchmark in an earnout calculation by which the target’s performance is
measured is usually a predetermined measure of revenue or an earnings stream; however, it can also be

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