A potential purchaser of a business and a corresponding seller often disagree on the value of the business, particularly in regard to sales projections. The purchaser may attempt to entice the seller with what it believes is a fair compromise – accepting the perceived over-inflated price asked for by the seller, but paying only a portion at closing, with the balance payable a few years later if the projected sales forecast is in fact achieved. The seller readily agrees, confident the business will absolutely grow and this so-called “earnout” will net the additional proceeds without fail. Sounds like a win for both parties – but is it too good to be true?
Earnout provisions allow a purchaser to condition a portion of the purchase price on the future performance of the purchased business. If the buyer does not have the cash available for full payment of the asking price, an earnout provision can be used to delay payment of the purchase price with certain conditions and parameters placed on paying the additional amount, such as meeting specified financial goals after the sale. While earnout provisions sound fairly reasonable and easy to apply in theory, in practice these provisions often result in hardships for both the purchaser and seller, who may have very different objectives post-closing. Once the seller has sold its business, it no longer has control of operations and can no longer make important decisions. Because earnout provisions are typically contingent on the business performing well after the sale, the seller has a strong interest in ensuring the business operates in a progressive manner; however, the buyer often wants to implement new or different strategies that will be beneficial in the long term, but that could result in revenue declining over the earnout period. Even though a seller may continue in a limited role after the sale, with the loss of control, the seller will be hard pressed to argue for strategies that would result in maximizing the earnout.
Earnout provisions can also be a problem for the buyer, who will need to be careful not to purposefully limit or minimize the earnout, which could result in litigation between the parties. Buyers typically do not have any duty to ensure or maximize an earnout. To counteract this potential problem, sellers may argue that an implied covenant of good faith and fair dealing exists on the part of purchaser which precludes the purchaser from engaging in conduct depriving the seller of the earnout benefit. However, proving that a purchaser has in fact breached this covenant also presents its own problems. Suits over a breach of earnout provisions can be expensive and can be difficult to prove on the part of a seller. One solution is to state that the purchaser will use its “best efforts” to maximize the chances that the earnout is attained. Again, however, this only provides minimal assurances to the seller as lawsuits can devolve into whose expert is more credible as to whether “best efforts” were in fact used by the purchaser.
Because courts have generally refused to fill gaps or provide additional terms in earnout provisions, such provisions should be drafted with as much clarity as possible and contextualized to fit the specific type of business at issue. An earnout provision should include which party is responsible for preparing relevant financial statements the earnout may be calculated from and what review and objection rights the remaining party has to such statements. The provision should also specify the accounting principles and procedures to be used in preparing the statements, and if necessary, be business or industry specific. A dispute resolution process should also be included to cover situations where the buyer and seller cannot resolve a disagreement over the earnout calculation. Without covering these specifics in detail, a seller runs the risk of not receiving any earnout compensation. Thus, it is important that earnout provisions and dispute resolution procedures be specified in detail in the purchase agreement – or, not used at all. From the seller’s vantage point, the best solution is to receive as much of the purchase price as possible at the time the purchase is closed.