Earn-out mechanisms are commonly used in M&A transactions involving the sale of shares or assets where the price (or part of it) is determined by reference to the future performance of the target company or business. There are as many earn-out formulations as there are transactions, but arguably the most common determinant is profits (as opposed to, say, turnover or net assets). Since earn-outs are commonplace, there is a substantial body of knowledge and experience about the key commercial issues and these are always hotly negotiated by sellers and buyers and their respective advisers. However, there has been scant judicial precedent on earn-outs. Until, that is, the recent High Court decision in Porton Capital Technology Funds v 3M UK Holdings Ltd.
Cutting through the detail, the earn-out provision under dispute imposed an obligation on the buyer to "diligently" seek regulatory approval and "actively" market the target's products. However, as it turned out, the buyer decided to terminate the target business after it acquired it, as it was unprofitable. As a consequence of the termination, no earn out payments were made to the sellers, hence the claim brought by them for breach of the obligations just referred to.
The court agreed that the buyer did not "diligently" seek regulatory approval, as it failed the objective test of reasonable application, industry and perseverance. The court also took the view that the buyer did not "actively" market the products, since this required its efforts to be backed by action, i.e. an element of proactivity was needed, which was missing.
The final point considered was whether the sellers had acted unreasonably in withholding their consent to the termination by the buyer of the target business. The court, applying established case law, concluded that the sellers had acted reasonably; the sellers were entitled to have regard to their own interests in maximising the earn-out payment and did not need to balance their own interests with those of the buyer.
What can we take away from this? Essentially, in order to mitigate the risk of a dispute of this nature arising, parties to an earn-out provision should ensure that the earn-out obligations are drafted as specifically as possible. For example, if the buyer agreed that it will "diligently" undertake some course of action in order to protect the earn-out for the sellers, then the agreement should define what, precisely, this means in the context of the transaction. Don't leave it to the courts to fill the gaps....
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
