Page 44 - M & A Disputes

payment per incremental dollar of earnings may be similar to the pricing multiple used by the buyer in
valuing the business.

In addition, it is also common for the parties to agree to a maximum earnout payout to the sellers. For
instance, using the example in the preceding scenario B, if the earnout provision provides that "in no
event shall the aggregate earnout amount exceed $2 million," then the earnout payout would be $2 mil-
lion instead of $4 million.

The duration of the earnout period(s) also varies depending on a provision of an acquisition agreement.
Generally, a longer duration will increase the amount of data available on which to compute the earnout
adjustment. However, as time passes, the target’s performance becomes increasingly based on the man-
agement of the business by the buyer or seller, rather than the value of the entity at closing. This situa-
tion may lead to disputes between the buyer and seller in determining the earnout adjustment.

Earnout Adjustments — Common Issues and Key Considerations

Postclosing earnout adjustment disputes can arise when the parties’ intentions are not effectively reflect-
ed in an earnout provision or are interpreted differently between a buyer and seller. In addition, a dispute
can arise when the seller or buyer believes that the postclosing operation is not managed in a way that
the parties intended throughout the earnout period. One of the greatest challenges in negotiating and es-
tablishing an earnout provision is balancing the needs of the buyer and seller. Typically, the buyer is fo-
cused on integrating the acquired business into the buyer’s operations and managing the business in a
manner that best achieves its short-term and long-term objectives. On the other hand, the seller is typi-
cally concerned that the acquired business is operated in a manner that maximizes the potential earnout
adjustment. In general, when the business is managed by the buyer (seller) postclosing, the seller (buyer)
often perceives the buyer (seller) to have taken actions to minimize (maximize) performance measures
and, therefore, the earnout adjustment. It is extremely difficult, if not impossible, to address all the pos-
sible postclosing issues related to an earnout provision. However, described subsequently are some
common issues that may arise in calculating earnout adjustments. These issues may be considered in
drafting and applying an earnout provision and navigating through the postclosing management of the
business.

Management Issues

A number of postacquisition management issues can put a buyer’s and seller’s interests at odds with
each other if these issues are not adequately addressed in an acquisition or earnout agreement.

The buyer often believes that it is in the best interest of the acquired company to make postclosing modi-
fications to the business. Although these decisions may be prudent and reasonable business decisions,
each decision could also have an impact on the earnout adjustment, and the seller may not believe that
such changes are in accordance with the intention of the earnout.

One common issue that arises in postclosing earnout adjustment disputes is what should be considered
revenue for the purpose of the earnout calculation. Practitioners may think that if revenue was to be cal-
culated in accordance with GAAP, then this may not be an issue. However, what if the buyer decided to
discontinue certain products of the target for various reasons, such as a decline in market demand, an in-
crease in costs, or because the buyer’s own products directly compete with the acquired company’s
products? Even if the buyer does not discontinue the product, what if the buyer is not willing to spend as
much on promotion of the acquired company’s product? What if the buyer decides to alter or terminate
some significant preexisting customer relationships or merge acquired product lines with the buyer’s

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