This is the first in a series of posts dealing with issues and trends in earnouts. In this initial installment, Warren Silversmith and Tania Djerrahian provide a general overview of the purposes and features of a typical earnout agreement, followed by a discussion of key issues arising in the negotiation of covenants relating to the post-closing conduct of the business.
Purposes and Features of an Earnout
An earnout can be an effective means of resolving differences between buyers and sellers with respect to the future prospects (and, by extension, present value) of the target business. Earnouts achieve this by making the ultimate purchase price partly contingent on actual future performance – in other words, by breaking the payment down into an up-front component and a post-closing payment or payments, the amounts of which (or in some cases the very existence of which) are tied to agreed performance milestones during a specified post-closing period.1 Where, for example, a business does not have a long track record, where it has significant potential for rapid growth, or where the vendor and purchaser cannot come to a meeting of the minds on purchase price, an earnout can bridge the valuation gap that often divides optimistic sellers from cautious buyers.
Because earnouts can give buyers and sellers the confidence to proceed with deals, they have become increasingly common. To be precise, studies indicate that earnouts are now included in roughly 20-25% of U.S. and Canadian transactions.2 However, as discussed below with respect to "post-closing conduct" issues – and in other contexts in subsequent posts in this series – earnouts create challenges as well as opportunities.
An earnout offers a practical and effective solution to a difficult problem. In order for an earnout to work, however, the negotiating parties need to reach agreement on a number of key points:
- Duration: In Canada, earnout periods are most typically 1 to 3 years but not infrequently run as long as 5 years.
- Classic or reverse earnout: The parties may wish to consider a "reverse earnout", in which the vendor receives the maximum amount on closing, having agreed to make payments to the buyer in the event that subsequent performance milestones fail to be met. Because reverse earnouts are the topic of the second installment in this series, we will not discuss them further at this point.
- Type of payment: The payment may be a specified dollar amount or it may be a multiple or percentage calculated with reference to the target's performance relative to a performance milestone set out in the earnout. In the latter case, there may be a ceiling on the payment.
- Number of payments: The earnout payment can be a one-time payment or made through multiple payments.
- Performance criteria: The performance criteria on which the earnout will be based can be non-financial (e.g. obtaining a new contract or the launch of new product), but are more commonly financial (e.g. revenues, earnings, EBITDA or net earnings).
- Impact of certain events: The parties may want to address the impact of certain events on the earnout. For example, they may wish to agree in advance what happens to the earnout if the employment agreement with a seller who is to maintain an active role in management post-closing is terminated during the earnout period. Another matter that can be useful to settle in advance is whether an acceleration of earnout payments will occur upon a change of control of the earnout assets.
- Calculation of the performance criteria: Where the earnout is based on financial performance criteria, parties may reduce the likelihood of future disputes by specifying (i) the rules for the calculation of the financial metric, including the precise elements to be included or excluded from the definition of the metric; (ii) the person who will be responsible for preparing the financial statements with reference to which the earnout will be calculated; (iii) the principles upon which those statements will be prepared, and (iv) the allocation of the various elements that go into the calculation of the earnout if the target's business is integrated into buyer's existing business.
- Future conduct of the business: The parties may consider what their respective rights and obligations should be with respect to future business decisions that may impact the performance of the target's business, and therefore the ability of the business to achieve the earnout, during the agreed post-closing period.
The remainder of this article will focus on the last of these issues, which tends to be one of the focal points of negotiations over earnouts.
Future Conduct of the Business
Defining rights and obligations relating to the future conduct of the business is essential, of course, because the degree to which earnout milestones are attained – and, by extension, the all-important amount of the earnout payment – can potentially be manipulated by the way the target business is run after the closing of the transaction. To deal effectively with "future conduct of the business" issues, two important points should generally be addressed:
- Seller's post-closing decision-making power (generally only in those transactions that envisage a continued active role for seller in the management of the business); and
- Buyer's post-closing decision-making power and (more generally) its overall ability to run the business.
After briefly outlining the general nature of covenants that typically deal with each of the above, we discuss a range of issues relating to negotiating strategies relating to earnouts and outline a practical earnout structure that can help address those issues.
Covenants relating to seller's post-closing business decisions
If seller maintains an active role in management post-closing, it may be tempted to run the business to maximize the short-term earnout rather than the long-term interests of the business. In many private equity deals, sellers who were managers of the business prior to closing will remain managers of the business after closing, as the private equity buyer may not possess the expertise or the resources to run the day to day operations of the business. In such cases, seller's ability to influence the earnout can be curtailed by making its power to make certain decisions subject to compliance with buyer's policies, procedures, budget and forecast or subject to buyer's approval.
Covenants relating to buyer's post-closing business decisions
As the owner of the business, buyer will generally possess the ability to dictate the way the business is run, even if seller remains in a management capacity without any of the express limitations to his or her powers that were discussed in the previous paragraph. This is significant, because if (for example) buyer makes a change to the business plan that was put in place by the business' pre-closing management or it fails to provide support to the business after the closing date, the post-closing performance of the business, and therefore the ability to attain the earnout milestones, may be affected. As a result, the parties will often consider negotiating covenants relating to the manner in which buyer will run the business during the earnout period.
Negotiating "future conduct of the business" issues in an earnout
The fundamental issue with negotiating earnout covenants lies in the inherent tension between the interests of seller and buyer, particularly as regards integration of the business with buyer's other businesses.
Typically, seller will agree to an earnout target that it is comfortable can be achieved if the business is conducted after closing in the same manner as it was conducted prior to closing. As such, seller will want the agreement to provide that the business will be conducted after closing "in the ordinary course of business" as conducted prior to closing, which could include:
- Running the business consistently with seller's last business plan for the target;
- Not transferring contracts to another business unit of buyer;
- Not transferring costs of another business unit of buyer to target;
- Maintaining a certain level of working capital or making certain expenditures;
- Not incurring debt of more than a specified amount;
- Not making changes to the product line or its branding; and
- Not terminating certain key employees.
By contrast, buyer will want the right to run the business that it acquired in the way it sees fit so that it can capitalize on new business opportunities and benefit from efficiencies it can gain by integrating the acquired business into its current operations. Buyer will generally want provisions (i) granting it absolute discretion in the way it runs the business, (ii) expressly allowing it to take certain acts or to omit to take certain acts, and (iii) not imposing an obligation to achieve or maximize the earnout.
Risks associated with negotiating specific covenants
If the parties were to negotiate a complete list of specific covenants addressing both parties' concerns, they would need to consider:
- All the business decisions that buyer may need to make during the earnout period that could potentially affect the earnout payment;
- Whether such decisions should only be made by buyer with seller's prior consent or with some other form of input from seller; and
- Whether there should be carve-outs to the decision-making rules established by the parties.
All these considerations can lead to protracted negotiations, which may in turn delay closing and drive up transaction costs. Even if the parties adopt this approach, it may not eliminate the risk of a post-closing dispute between the parties. The future is unpredictable and even an agreement with a long list of negative and positive earnout covenants is not likely to address all of the circumstances that may arise. A focus on producing a nearly unending list of covenants also would not provide practical guidance on how to resolve disputes and may result in the parties being less amenable to resolving disputes without litigation.
Risks associated with silence
In the absence of provisions regarding buyer's ability to run the business during the earnout period, there is a heightened risk of post-closing litigation. In the U.S., sellers have sued buyers for taking or failing to take actions that allegedly affected or would have affected the amount of the earnout payment. They have done so on various grounds, including that buyer breached implied duties such as the implied covenant of good faith and fair dealing in the performance of its obligations3. While the outcomes of these U.S. cases tend to be fact-specific, some inferences may be drawn:
- The courts will look to the agreement for guidance. They will not contradict the express terms of the agreement.
- The courts are more likely to find a breach of the implied covenant of good faith and fair dealing where, based on the agreement, the parties had not anticipated some contingency during negotiations and had they done so, they would have come to an agreement with respect to that contingency. This is more likely to be the case where buyer does something that seriously impedes the business' ability to achieve the earnout, or where buyer acts arbitrarily, unreasonably or in bad faith.4
- The courts are less likely to find a breach of the implied covenant of good faith and fair dealing where, based on the agreement, seller anticipated that buyer may need to take certain actions or make certain decisions to achieve the earnout but failed to bargain for covenants regarding such actions or decisions.5
- Even where the courts find a breach of the implied covenant of good faith and fair dealing, they may have difficulty in quantifying the effect on the earnout payment.
A similar argument based on a breach of a duty to act in good faith could be made by a seller in Canada. In the common law provinces (i.e. all provinces other than Quebec), the strength of such a claim is not clear, as Canadian common law has not traditionally applied "good faith" obligations to the performance of ordinary commercial contracts, although there are signs that such obligations are increasingly gaining judicial recognition in some situations.6 In this respect, Quebec resembles the U.S. more than it does the rest of Canada, as its civil law expressly recognizes a duty of good faith in the performance of contracts (See Art. 6, 7 and 1376 of the Civil Code of Quebec).
Finding a practical middle-ground approach
Each of the two alternatives considered to this point – silence with respect to the operation of target's business and the creation of a comprehensive list of earnout covenants – carries the risk of costly post-closing litigation. Therefore, parties may in some cases agree to try a middle-ground approach that attempts to address their respective needs while providing an efficient dispute resolution mechanism. Particularly in acquisitions by private equity buyers, we have recently been seeing a number of agreements in which the parties have structured earnout provisions that address: (i) seller's right to achieve the specified earnout target, (ii) buyer's right to run the business as it sees fit, and (iii) how to deal with disputes over the impact of buyer's decisions on the earnout payment. In such agreements, the parties typically agree that:
- Buyer is the owner of the business and can run the business as it sees fit;7
- If any act or omission of buyer that is outside the ordinary course, other than an act or omission required to comply with law or specifically permitted or required by the terms of the agreement, has a negative impact on the amount of the earnout payment, buyer will make an equitable adjustment to the earnout payment in favour of seller; and
- If buyer and seller disagree on whether an equitable adjustment is due and/or the amount of such adjustment, they will first try to resolve the dispute in good faith. Should they fail to come to an agreement, each has the right to submit the dispute to an independent third-party auditor for review. The auditor's determination will be final and binding on parties.
In negotiating an earnout, the parties should consider
addressing issues relating the target business' performance
during the earnout period, otherwise they risk converting
"today's disagreement over price into tomorrow's
litigation over outcome".8 It is often complicated
to deal with the parties' obligations in respect of future
business decisions that may affect the target business'
performance during the earnout period. However, experienced counsel
will usually be able to guide the parties through this process to a
successful conclusion. If seller continues to manage the business
after closing, the parties should consider the effect of
seller's future business decisions on the earnout. In every
case, the parties should consider buyer's post-closing
decisions in respect of the operation of the target's business
and its impact on the earnout.
In order to reduce the risk of litigation, parties should focus on solutions that provide general guidelines for decision making powers, address seller's rights with respect to buyer's decisions that have a negative impact on the ability to achieve the earnout and provide practical recourses in case of dispute. In the future, we expect to see more earnout agreements that provide for a mechanism that protects seller's right to maximize the earnout without interfering with buyer's right to run business, while at the same time minimizing the risk of a costly court battle.
1 A variation of this concept is the reverse earnout, which will be discussed in a subsequent post in this series.
2 In the ABA's 2013 Private Target M&A Deal Points Study, 25% of the transactions included in the study included an earnout and in the ABA's 2012 Canadian Private Target M&A Deal Points Study, 21% of transactions included in the study included an earnout.
3 See O'Tool v. Genmar Holdings, Inc., 387 F.3d 1188 (10th Cir. 2004), Airborne Health, Inc. v. Squid Soap, LP, 984 A.2d 126 (Del. Ch. 2009), Fireman v. News America Marketing In‐Store, Inc., 2009 U.S. Dist. LEXIS 91236 (D. Mass. 2009), Yarborough v. DeVilbiss Air Power Inc., 321 F.3d 728 (8th Cir. 2003), and American Capital Acquisition Partners, LLC v. LPL Holdings, Inc., CA No. 9490–VCG, 2014 WL 354496 (Del. Ch. Feb 3, 2014).
4 In American Capital Acquisition Partners, LLC v. LPL Holdings, Inc., CA No. 9490 –VCG, 2014 WL 354496 (Del. Ch. Feb 3, 2014), the Delaware Chancery Court found that LPL and LPL Financial breached the implied covenant of good faith and fair dealing by intentionally impeding Concord-LPL's ability to generate revenue by shifting employees and customers from Concord to Fortigent [a subsidiary of the buyer] in order to avoid both earn-out payments under the continent purchase price provision of the SPA and additional payments based on the compensation targets in the employment agreements. The decision was based on the fact that "taken together, the contingent purchase price provision in the SPA, the compensation targets in the employment agreements, and Section 2.06(c), which provides for the calculation of revenue in order to determine the payments to which the Plaintiffs are entitled under the two former agreements, demonstrate that, had the parties contemplated that the Defendants might affirmatively act to gut Concord-LPL to minimize payments under the SPA and employment agreements, the parties would have contracted to prevent LPL from shifting revenue from Concord-LPL to Fortigent."
5 In American Capital Acquisition Partners, supra n. 4, the Delaware Court of Chancery did not find that buyer breached the implied covenant of good faith and fair dealing by failing to make technological adaptations necessary for LPL Financial to provide custody services to Concord in order to help Concord-LPL to reach the earnout milestone. The court's decision was based on the fact that parties "anticipated and discussed, prior to signing the SPA and employment agreements, that it would be helpful to make technological adaptations in order to integrate Concord's and LPL Financial's services. At that time, the Plaintiffs chose not to bargain for specific language requiring LPL to make those adaptations."
6 See, for example, this recent statement by Justice Perell of the Ontario Superior Court of Justice: "[W]hile Canadian courts have been cautious about the scope of a doctrine of good faith in the performance of contracts, the doctrine is developing, and it does have a role to play. As Associate Chief Justice O'Connor also noted in Transamerica Life ...: '[C]ourts have implied a duty of good faith with a view to securing the performance and enforcement of the contract made by the parties, or as it is sometimes put, to ensure that parties do not act in a way that eviscerates or defeats the objectives of the agreement that they have entered into.'" Rio Algom v. Canada (Attorney General), 2012 ONSC 550, para. 51, citing Transamerica Life Canada Inc. v. ING Canada Inc. (2003), 68 O.R. (3d) 457 (C.A.), para. 51.
7 In some cases, the agreement also lists a number of acts or omissions that buyer is permitted to take or make without seller consent or input.
8 Airborne Health, Inc. v. Squid Soap, supra, n. 3.
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.