Page 46 - M & A Disputes

the goodwill impairment as a legitimate expense to arrive at net income for the earnout calculation be-
cause it was a cost incurred after the acquisition. However, the seller may object to such a claim on the
basis that, without the acquisition itself, there would not have been any goodwill to impair.

Additionally, when an earnout is based on a net earnings measure, many of the common issues discussed
in the context of working capital and net asset adjustments (see chapter 2, "Postclosing Purchase Price
Adjustments," of this practice aid), such as GAAP versus consistency, are also common issues in
earnout adjustment disputes, only they are manifested differently. Expenses that affect net earnings and
depend heavily on management estimates are often susceptible to disputes. Some examples include al-
lowances for doubtful accounts, reserves for excess and obsolete inventory, environmental reserves, and
legal reserves. These estimates are generally prepared with a high degree of judgment and subjectivity;
therefore, they are often targets for a buyer looking to decrease or a seller looking to increase the earnout
adjustment.

Another common issue is the treatment of costs that are designed to benefit periods beyond the end of
the earnout period, such as research and development expenses and marketing costs of a new product.
Under GAAP, these costs would be expensed as incurred. However, the question may arise about
whether these costs should affect the earnout calculation when the seller is not receiving the benefit of
those costs.

To address these risks, an earnout provision may include clauses, such as "the net income for the pur-
pose of earnout calculation will be prepared in a manner consistent with the past practice of the seller,"
or something more specific, such as "the purchaser shall not make expenditure in excess of $X during
the earnout period, unless it is agreed to by the seller." However, it is often difficult to include such
clauses because such clauses will limit the buyer’s ability to manage the business after the acquisition.

It is often said that earnout provisions are better envisioned than employed. This statement highlights the
practical challenges of operating a business for the benefit of both the buyer and seller while being re-
strained and, in some cases, burdened by the contractual requirements of the earnout provision.

Basis of Accounting to Measure the Target’s Performance

The parties should also consider the basis of accounting used to measure the target’s performance. Ac-
quisition agreements typically require accounting for the target’s performance in accordance with GAAP
consistently applied with the target’s historical accounting practices and policies. GAAP is often the pre-
ferred basis. However, other options and varying practices within GAAP are also to be considered, such
as the following:

 International Financial Reporting Standards

 Tax or regulatory basis of accounting

 A modified basis of accounting that excludes certain specified revenue and expenses, such as va-
cation expenses on a pay-as-you-go basis rather than accrual basis, an exclusion of income tax,
and an exclusion of extraordinary gains and losses

Similar to working capital disputes, as discussed in chapter 2, the basis of accounting and GAAP versus
consistency are also common issues in earnout adjustment disputes.

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