Practical Considerations In Drafting Earnout Provisions

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Bass, Berry & Sims

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It is often said that an earnout can help a buyer and seller reach terms when there's a gap in terms of purchase price between a buyer and seller.
United States Corporate/Commercial Law
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It is often said that an earnout can help a buyer and seller reach terms when there's a gap in terms of purchase price between a buyer and seller. This gap is usually the result of either a disagreement as to the future performance of the business being sold or an attempt by a buyer to ensure that the business being purchased maintains its economics for some period following the closing of the transaction.

Although earnout may help bridge this gap, it is often the subject of post-closing disputes and litigation. This article offers some practical considerations that should be taken into account in drafting and negotiating earnout provisions.

Initial Considerations

Before putting pen to paper, counsel should have a clear understanding of the motivations behind the earnout and the transaction from both the seller's and buyer's perspective. Obviously, any earnout is, in essence, a payment based upon some future event or outcome occurring that results in additional consideration being paid to the seller that a buyer and seller could not agree upon at the time of the transaction. For example, is this earnout a growth earnout that requires the acquired business to outperform historical operating results (growth earnout)? Alternatively, is the earnout a maintenance earnout that only requires the acquired business to maintain historical performance (maintenance earnout)? Lastly, is the earnout directly tied to the occurrence of an specified event, such as the renewal of a material contract (occurrence-based earnout)? Earnouts can take all shapes and forms, and it is important to understand the dynamics of the trigger event when drafting the earnout provisions as discussed in more detail below.

Counsel should also have a clear understanding of how likely is it that the earnout is achieved from both the buyer's and seller's perspective. For example, growth earnouts, by their nature, will be far less likely to be achieved than a maintenance earnout, and there will likely be more negotiations around the buyer's efforts to help achieve the earnout. Similarly, with respect to an occurrence-based earnout, if a buyer will be able to influence the outcome of the event giving rise to the earnout, there will again be heightened negotiations around buyer's efforts to cause the event to occur.

Counsel should also take into consideration whether the seller will be involved in the business going forward. Take for example a private equity transaction where a business is acquired by the private equity sponsor, and the purpose of the acquisition is to use the acquired business as a platform for future acquisitions. In this type of transaction, one would anticipate that the seller will be actively involved in the business going forward and will have more control over the outcome of the earnout. Alternatively, if the seller is walking away from the business, then counsel for seller should be focused on reporting requirements and guardrails around buyer's actions that could negatively affect the ability to achieve the earnout.

Lastly, counsel should have a clear understanding of the buyer's future plans with respect to the business. For example, will the business be operated as a standalone business, or will be it be assimilated into an existing business? If assimilated, tracking the earnout will likely be more difficult depending on metrics and provisions will need to be added to address such difficulties.

Putting Pen to Paper

Depending on the complexity of the earnout, drafting the actual earnout piece can be challenging. Vagueness can lead to litigation in the event the earnout is not clearly articulated in the purchase agreement. Consider these practical suggestions in drafting the earnout provision:

  •  If the earnout is tied to a financial metric, one should consider attaching an excel sheet or other example calculations, if appropriate. In addition and if tied to a financial metric, counsel should address the accounting around such metric. For example, will the determination be made in accordance with GAAP or some other accounting standard (for example, on a cash basis)?
  •  In the event of an occurrence-based earnout, counsel should clearly articulate what that event is. By way of example, if the event is that the seller remain employed for a certain period of time, counsel should address what happens if the employee is terminated without cause or as a result of death or disability. If the event involves the renewal of a contract, counsel should address the terms of such renewal (for example, the number of years of such renewal, will an auto-renewal qualify, the economic terms of such renewal (e.g., the same or better terms) and renewals with a successor or an affiliate of the counterparty).
  • Counsel should clearly articulate if there is a pro rata payment based on attaining a threshold target and whether any pro rata payment is prorated from 0 to 100% between the threshold and the target or whether once the threshold is achieved the amount earned is the percentage of the earnout achieved up to the target.
  •  Counsel will need to address what happens if there is a dispute regarding the achievement of the earnout. Although with an occurrence-based earnout the dispute resolution procedures generally applicable to disputes under the purchase agreement may be appropriate, earnouts based on financial metrics may better be resolved using an arbitrating accountant subject to the same type of resolution procedures that one typically uses in settling networking capital and other purchase price adjustment disputes.

The next consideration in drafting the earnout provision is what, if any, covenants should be included in the earnout provision. As mentioned above, it's important to understand the motivation of the parties and the circumstances post-closing that could affect the achievement of an earnout. Typically, one can expect a good amount of negotiation around the covenants given that a buyer will want as much freedom as possible to run the business post-closing and a seller will want as many protections as possible to ensure that it will receive the earnout consideration. The role of a seller in the acquired business post-closing is important to take into consideration when examining covenants. Included below are a few practical considerations:

  • At the very least, a buyer should agree to not take any action in bad faith with the intent to diminish the seller's ability to achieve an earnout. A seller will typically push for more protections, which range from a covenant on the part of buyer to not take any action if the reasonable expected outcome would diminish the ability to reach the earnout to a more advanced protection, saying the buyer will affirmatively use commercially reasonable efforts to achieve the earnout.
  • The alignment of interests between a buyer and seller will often inform the level of efforts that a buyer has to use to assist in the achievement of the earnout. For example, if the acquired business will operate as a standalone business going forward and both parties have the same motivation in achieving the earnout, the interests of a buyer and seller may be so aligned that a covenant around the buyer's efforts is less controversial. Alternatively, if the acquired business is being integrated into an existing business and the earnout is based on the targeted business achieving some financial metric, a buyer's interest will be different than the seller's because the buyer may be focused on the operating results of the integrated business as whole, which may come at the expense of the acquired business. Typically, counsel for the buyer will want to set definitive standards, whereas counsel for the seller may argue for more vague standards, such as "commercially reasonable efforts" to help achieve the earnout to preserve a seller's right to dispute the results if negative.
  • Depending on the type of earnout, covenants around resources may be important. Take for example a growth earnout based on achieving a certain level of EBITDA. In such an example, a seller will want to ensure that the acquired business has sufficient resources (e.g., capital and employees) to reach the earnout target. In addition, if appropriate, a seller may want to prevent the buyer from redirecting resources, employees, customers and suppliers away from the acquired business to the buyer's other businesses.
  • Counsel should be mindful of how the earnout will be tracked. For example, if based on a financial metric, counsel for the seller may require a covenant around maintaining the acquired business as a separate reporting unit. In addition, periodic reporting requirements may be appropriate and a seller may want to have the right to periodically audit the results of operations. Reporting requirements will oftentimes be informed by the length of the earnout, with a longer earnout period justifying the need for periodic reports.
  •  Covenants will often need to be specifically tailored to the earnout and one size does not fit all. Counsel should consider the earnout targets and the post-closing world in which the acquired business will be operating (e.g., as integrated with an existing business or operating as a standalone business) and draft appropriately around the unknowns that may occur following closing.

In addition, counsel should consider what, if any, events will result in an acceleration of an earnout. For example, if the acquired business is sold, should the earnout be paid in full? Or if the buyer breaches its undertakings with respect to an earnout, should this accelerate payment? Similarly, counsel should consider whether the earnout should be accelerated upon bankruptcy. Acceleration events should be carefully considered in light of the earnout taken as a whole and specifically tailored to the goals of the earnout.

Avoiding the Pitfalls

There are numerous pitfalls and considerations that should be taken into account in drafting and negotiating earnouts. A few additional considerations are set forth below.

  • Counsel should be mindful of existing or future credit facilities of the buyer. Oftentimes, a buyer will require that the payment of any earnout be subordinated to the terms of any credit facility. Counsel for the seller should be aware of this risk and the "what if" scenario in the event a subordination clause is triggered.
  • Financial definitions should be drafted precisely and may need to address uncertainties. For example, during the COVID-19 pandemic, many earnouts based on EBITDA or other financial metrics were adversely affected. Although it may be impossible to anticipate all future scenarios, counsel for a seller may push for provisions allowing for relief against circumstances occurring outside of the acquired business.
  • Counsel should also be mindful of any antitrust considerations. For example, counsel should consider whether an earnout impacts any Hart-Scott-Rodino analysis or requirements.
  • If the earnout is in the healthcare space, healthcare counsel should be consulted to confirm that the earnout does not raise regulatory concerns. This is especially true in the physician practice context.

Conclusion

In conclusion, drafting earnout provisions requires thoughtful consideration of the deal terms, the post-closing plans for the business, and the facts and circumstances that may affect the achievement of the earnout. Specificity is key in avoiding disagreements down the road.

Originally published by Bloomberg Law.

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.

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