Earn out provisions have become increasingly popular in Canadian private M&A transactions, appearing in 33% of surveyed deals in 2021.1 They are intended to provide a "win-win" scenario for buyers and sellers. Earn outs are especially useful to bridge a valuation gap between the seller and buyer or to incentivize a seller to continue with the business post-closing. In our experience, earn out provisions in M&A agreements are growing in complexity, resulting in a higher risk of disputes among buyers and sellers when it comes time to measure whether an earn out will ultimately be paid to the sellers. This article provides practical takeaways for negotiating and drafting earn out provisions, informed by Canadian and US jurisprudence.
Earn out mechanisms
An M&A agreement can include a variety of post-closing payment obligations, contingent on the achievement of financial targets or operational milestones by targeted dates. Among other things, these can include:
- Meeting certain levels of revenues, profits or EBITDA
- Receiving licenses or regulatory approval
- Meeting development milestones
- Achieving certain levels of production
Earn out disputes are highly fact-specific
Earn out provisions, like other provisions in M&A agreements, will be interpreted based on the express wording negotiated by the parties and the surrounding circumstances in which the agreement was signed, in a fashion that accords with sound commercial principles and good business sense while avoiding commercial absurdity.
Earn out disputes have occurred in various circumstances, including when parties disagree on:
Whether a buyer's post-closing conduct breached covenants: In SRS v. Valeant, the Delaware Court of Chancery considered whether the buyer breached covenants in the merger agreement to use "Diligent Efforts" (as defined) to develop and commercialize a drug. The sellers also claimed that the buyer had breached the implied covenant of good faith by increasing the drug's price "to a cost that made it unaffordable to millions of women and at which [insurers] would not cover the drug." The Court of Chancery refused to dismiss the claim, finding that several claims potentially implicated the implied covenant of good faith.
Whether a buyer was obliged to maximize the earn out payment: In Winshall v. Viacom,2 the Delaware Supreme Court held that a buyer had not breached the merger agreement and duty of good faith by making a bona fide business decision that resulted in earn out payments not being triggered. The seller claimed that the buyer had not negotiated lower distribution fees with a third party until just after the earn out period had ended. The Court noted that the merger agreement did not oblige the buyer to ensure or maximize payment of the earn out.
Whether a buyer took steps that were intended to prevent an earn out payment: In Lazard Technology Partners, LLC v. Qinetiq North America,3 the Delaware Supreme Court strictly interpreted the merger agreement's earn-out provision which prohibited the buyer from "tak[ing] any action to divert or defer [revenue] with the intent of reducing or limiting" earn outs. The Court held that while the buyer knew that its actions would likely reduce the likelihood of an earn-out payment, its actions were not motivated by a desire to avoid an earn out payment.
Whether a seller could influence the triggering of the earn out payment: In Pacira Biosciences, Inc. et al. v. Fortis Advisors LLC et al.,4 the Delaware Court of Chancery held that sellers who, post-closing, (1) attempted to influence the employees of the acquired business to meet the triggering criteria for the earn out payment (so that the sellers would get paid) and (2) sought to ensure that third party reimbursement rates would trigger the earn out milestone, did not breach the terms of the merger agreement. The Court also held that the sellers' "non-threatening business communications" to the employees were not contrary to the duty of good faith.
Whether a buyer could unilaterally cease making earn out payments because of inaccurate information: In GreenStar IH Rep, LLC v. Tutor Perini Corp, the buyer and seller agreed to calculate earn out payments based on the acquired business' pre-tax profits calculated by the buyer. The buyer stopped making payments because it alleged that the seller's CEO, who had remained with the acquired business, provided the buyer with inaccurate information that led to the buyer's calculation of inflated pre-tax profits. The Delaware Court of Chancery rejected the buyer's position, noting that the earn out provisions did not allow the buyer to attack its own calculations. The merger agreement made the buyer's calculations binding unless they were was objected to by the seller's representative within a specified timeframe.
Which new business should be included in the earn out formula: In Whiteside v. Celestica International Inc.,5 the Court of Appeal for Ontario considered whether a large new contract should be included in the determination of the earn out formula. The new contract was won by the buyer post-closing but "run" from the seller's office with the seller's former employees. The Court held that the new contract should be included based on the wording of the agreement, the letter of intent, and the fact that similar projects had also been included.
- To state the obvious, the M&A agreement should include
clear language on how earn out payments will be calculated and the
parties' post-closing obligations. The Court will not imply
terms that are not bargained for by the parties. For instance,
consider whether to negotiate:
- a covenant that the buyer seek to maximize the earn out payment.
- a covenant requiring the buyer to take certain actions (e.g. commercializing a new product, effecting certain capex) or not take certain actions (e.g. terminating the employment of a seller during the earn-out period).
- a calculation schedule setting forth the rules to calculate the earn-out criteria (e.g. EBITDA) and how to account for certain post-closing matters (synergies, volume-discount, new customers).
- a covenant requiring the buyer to operate the business consistent with past practice, and how past practice should be defined, including accounting standards and principles that apply. In the absence of such a covenant, a Court will likely not second-guess the buyer's bona fide business decisions. When negotiating post-closing covenants, be mindful of the standard of effort applicable to the covenants (best efforts, commercially reasonable efforts, etc.).
- covenants about whether the buyer is allowed to rebrand the acquired business or its product/services, remove key employees and consultants, and make other changes to the business that are bona fide but may also interfere with achieving or maximizing the earn out payment.
- a term allowing the buyer to offset indemnity payments against the earn out payment. In Coolbreeze Ranch Ltd. v Morgan Creek Tropicals Ltd.,6 the BC Supreme Court rejected a buyer's attempt to set off damages it claimed from the seller's alleged misrepresentations in the share purchase agreement, noting that the two issues were unrelated because any devaluation of the acquired business from the alleged misrepresentation had no impact on the earn out payment.
- a term for the earn-out calculation be performed by a neutral third party, with both the buyer and the seller having the opportunity to provide feedback to the third party or object to the calculation on limited grounds, such as the use of inaccurate information.
- several scenarios of how the earn out mechanism will work based on different foreseeable scenarios with sample calculations being appended to the definitive agreement.
- The buyer should be mindful of post-closing conduct. Such conduct will not only impact an assessment of the buyer's compliance with its covenants, but may also be used to interpret any ambiguity in the M&A agreement.
- Parties should ensure that documents outside the M&A agreement (term sheets, letters of intent, board presentations, etc.) clearly and consistently describe how earn out payments will be calculated. Such extrinsic evidence may be used to interpret ambiguous provisions.
- Parties should be mindful of blindly subjecting disputes over earn out provisions to a binding determination by an independent accountant. Instead, earn out payments should, whenever possible, be subject to a dispute resolution process and arbitration if a negotiated resolution is not possible. As the cases above illustrate, many disputes require a determination of contested facts and whether parties have acted in good faith. In certain circumstances, sellers may also insist on an acceleration of the earn-out payment in the event of a breach of certain covenants.
1. "What's Market: Earn Outs", Practical Law, Thomson Reuters (Oct. 5, 2022).
2. C.A. No. No. 39, 2013.
3. C.A. No. 6815-VCL.
4. 2021 WL 4949179 (Del. Ch. Oct. 25, 2021).
5. 2014 ONCA 420.
6. 2009 BCSC 151.
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