You should consider the scope and nature of the
information to be disclosed to calculate an entitlement to payment
under an earn-out – and then document it.
Earn-outs are often used where there is uncertainty about the
performance of a target business post-completion, and a buyer
(particularly one which may not have the expertise to run the
business) wants to give one or more sellers, who will remain with
the business, an incentive to achieve certain results. Given their
role, how an earn-out is calculated is very important - the
earn-out provisions should be sufficiently detailed to avoid
The problem is that, even if an implied term regarding earn-out
information might seem appropriate, it can be very difficult to
imply that term into a contract, especially if the contract is
detailed and a result of extensive negotiations – as parties
recently discovered in the Federal Court (Barnes v Forty Two
International Pty Limited  FCAFC 152).
Earn-outs and the licence fee
Mr Barnes and Mr Hawksley agreed to sell shares in Forty Two
(and a related company) to BlueFreeway Ltd. The purchase price was
payable in tranches, including two payments calculated by reference
to earnings before interest and tax (EBIT) targets for the sale
companies for nominated financial years. Mr Barnes and Mr Hawksley
were to remain directors of Forty Two after completion and the sale
documentation contained detailed provisions regarding the
calculation of the EBIT results and the reporting of financial
information by the sellers and BlueFreeway in this respect.
After completion, Mr Barnes and Mr Hawksley negotiated a licence
for Forty Two which resulted in it receiving a significant fee from
a third party licensee. This had a positive effect on EBIT and so
would increase the payments to be made to Mr Barnes and Mr Hawksley
under the sale. The licensee struggled to obtain funding to pay the
licence fee, so Mr Barnes and Mr Hawksley helped procure the
necessary financing by personally guaranteeing a loan.
Mr Barnes and Mr Hawksley then decided to leave the business and
received payments based on Forty Two's EBIT (which included the
receipt of the licence fee).
The dispute turns into litigation
At trial, BlueFreeway successfully argued that the failure of Mr
Barnes and Mr Hawksley to disclose their role in assisting with the
funding of the licence fee breached an implied term of that
agreement. The implied term was that Mr Barnes and Mr Hawksley
would disclose to BlueFreeway "all information known to them
which might become relevant to the [EBIT] calculation".
BlueFreeway also successfully argued that it had lost an
opportunity to negotiate the exit arrangements with Mr Barnes and
Mr Hawksley with knowledge of their role in procuring the finance
for the licence fee.
The trial judge decided, amongst other things, that the implied
term was necessary, that it filled a gap in the sale documents
regarding the reporting obligations for the EBIT calculation and
that, if the term was proposed in negotiations, it would have been
documented by the parties.
The Full Court disagreed, allowing the appeal from Mr Barnes and
Mr Hawksley. Amongst other things, the Court said that:
the proposed term was not necessary to give business efficacy,
nor was it obvious – the sale agreement contained a number of
detailed provisions that dealt with the provision of financial
information to and from BlueFreeway for the calculation of the
EBIT. Essentially, the sale agreement operated effectively without
the implied term; and
the proposed term was unclear and oppressively broad –
what does information known to the sellers which "might become
relevant" to the calculation of the EBIT actually mean?
Be clear about disclosure obligations
In the case of earn-out provisions where, as was the case here,
the sellers remain with the business after completion and the
exchange of information is critical, parties should consider the
scope and nature of the information required to be disclosed to
calculate an entitlement to payment. A similar comment applies in
relation to other post-completion payments - the scope and nature
of the information used to calculate those payments should also be
appropriately set out.
Parties should expressly document these arrangements in
reasonable detail, and it is particularly important for parties to
be aware that while an implied term may seem appropriate, there is
a high bar to be cleared before any such term will be implied. This
is particularly the case where the relevant contract is detailed
and was the subject of extensive negotiations involving legal
Clayton Utz communications are intended to provide
commentary and general information. They should not be relied upon
as legal advice. Formal legal advice should be sought in particular
transactions or on matters of interest arising from this bulletin.
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