Page 45 - M & A Disputes

preexisting product line? In these cases, revenue may be determined in accordance with GAAP, and the
buyer may claim that it should be the base revenue for the earnout calculation. However, the seller may
claim that revenue would have been much higher if it was not for the buyer’s decision to discontinue or
sell less of the acquired company’s products.

On the other hand, the buyer may also develop a new product that did not exist at the time of closing.
The buyer may claim that revenue from such product should not be considered for the purpose of the
earnout calculation; alternatively, the seller may claim that it should be included. This dispute may arise
if the earnout provision does not address how revenue from such products is to be dealt with in relation
with the earnout calculation.

To proactively address these issues, it is not uncommon for the earnout provision to include specific
clauses, such as "the purchaser shall be under no obligation to continue business line A and may, at any
time, without limitation or notice to the seller, discontinue business line A," or "revenue from products
X, Y, Z should be considered for the purpose of the earnout calculation."

Even if there are no specific clauses, it is often the case that the earnout provision includes clauses that
broadly address these potential issues. Examples of such clauses include "the purchaser shall operate the
business in a manner consistent with its past practices and operations," and "the purchaser shall maintain
the business as a separate business during the earnout period."

Another common issue is how to deal with a merger and acquisition (M&A), other than the transaction
itself. If the buyer is in an expansion mode, it is not uncommon for the buyer to purchase multiple com-
panies in the same line of business. Similarly, the buyer may decide to sell some or all of the acquired
business during the earnout period. Determination of the impact on the operations from other acquisi-
tions is also a common cause of earnout disputes if it is not specifically addressed by the earnout provi-
sion.

To deal with other M&A issues, the seller may request that the buyer have an obligation to buy out the
earnout at a mutually acceptable price in the event of a merger or sale of the seller’s business, but such
buyout provisions can also be the source of disputes in determining the amount of the buyout.

Revenue Versus Net Earnings Stream

As previously mentioned, 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.
It is typically in the best interest of sellers for the earnout to be based on gross revenue, but a net earn-
ings measure (for example, net income, EBIT, EBITDA, gross profit, and so on) may be in the best in-
terest of buyers. Buyers typically prefer a net earnings measure because increased revenues do not nec-
essarily translate into increased profits. On the other hand, sellers typically prefer the gross revenue
measure because it is easier to measure, and it presents fewer opportunities for buyers to manipulate
such a gross revenue measure compared with a net earnings measure that has more variables that may be
used by buyers to reduce the amount of the earnout adjustment.

For example, a buyer may include a number of nonrecurring expenses, such as restructuring charges, as-
set write-downs, changes in accounting principle, and acquisition costs, to reduce the net earnings meas-
ure. That way, the earnout adjustment will be lower. In this situation, it is often the case that the buyer
claims that the net income is prepared in accordance with GAAP, and the seller claims that inclusion of
such costs is not in line with the intent of the acquisition or earnout agreement. For example, one such
issue that may arise is the treatment of goodwill impairment from the acquisition. The buyer may claim

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