Agreements for the sale of a company (including asset purchase agreements) sometimes contain earnout provisions whereby some portion of the purchase price is paid long after closing and is dependent upon the performance of the company after the buyer takes ownership and operates the company for a period of time. This often happens when the buyer and seller cannot agree on the purchase price. Earnout agreements are fertile ground for litigation because the consideration paid to the seller is dependent upon the buyer’s efforts and competence as well as accurate measurements of the company’s profitability. As such, sellers should be careful when using them. Nevertheless, if an earnout is going to be used, clear, understandable language establishing a standard of diligence along with measurable metrics will result in an earnout agreement that is far more workable than one dependent upon critiquing the parties’ efforts and behaviors to ferret out compliance with the implied covenant of good faith and fair dealing as it pertains to the earnout provisions.
The buyer typically benefits from more broadly stated generalizations regarding the buyer’s duties, which leave the door further open for good faith claims, which are rarely successful. In contrast, the seller benefits from clearly stated, measurable benchmarks and metrics related to the buyers’ diligence during earn out periods. The buyer always wants as much control as possible over the acquired business while seeking to minimize future payments. The seller, on the other hand, wants to stay involved to ensure that the buyer diligently develops the business and maximizes future payments to the seller. This often makes negotiating an earnout agreement difficult, and sellers often try to rely upon good faith litigation to remedy poor negotiating outcomes.
There are a few primary considerations in drafting an earnout agreement:
- The length of the earnout period?
- >Who controls the business operations during the earnout period?
- How and by what measure are earnout payments triggered?
- The amount of the earnout payment?
- Who monitors the buyer to ensure compliance?
Clarity and precision are the keys to avoiding litigation in drafting earnout agreements. The language defining milestones must be unambiguous and terminology should be clear, and examples are often helpful to explain how the earnout provisions work. Indeed, there are many reported cases holding that courts will not rewrite poorly drafted earnout agreements. From the buyer’s perspective, provisions geared towards granting sellers significant control of operations post-closing should be avoided to instead allow the buyer to conduct business as it chooses, and implied duties of good faith and fair dealing may be disclaimed.
From the seller’s perspective, drafting pointers include:
- Specific and measurable metrics should be used, e.g., growth in the number of employees, growth in the number of accounts, growth in net profit, etc.
- Terms that require the buyer to use “best efforts” are too broad and undefined.
- Limitations on the buyer’s ability to dispose of assets should be limited or the consequences and effect on the earnout calculation should be clearly stated.
- Similarly, the buyer’s ability to spin off business lines should be limited or the consequences and effect on the earnout calculation should be clearly stated.
- Considering limitations on the buyer’s ability to remove a proven sales force to replace it with “its own people.”
- Considering other concrete measurements, like investment in technology and marketing.
- Avoid conflict by clarifying in advance accounting language to be used by the buyer and thus, determine whether earnout milestones have been met. Avoid using metrics based on “net” numbers in favor of “gross” numbers because net numbers are subject to manipulation.
Again, the more general the terms of the earnout, the more likely a claim under an implied covenant will result. As such, specificity, clear language and metrics that are unambiguous and immune from manipulation are best from a seller’s perspective.
Patrick J. Van Zanen