Earnout disputes

What is an earnout?

In the context of Mergers and Acquisitions, an earnout is an agreed mechanism where a proportion of the purchase price payable by the buyer is contingent upon the future performance of the acquired company.  

To illustrate how earnouts work, we have set out below a simple example of how an earnout might be structured.  

Company A has agreed to purchase 100% of the share capital in Company B. The agreed purchase price is £50 million, with £35 million paid on completion and the remaining £15 million payable based on Company B meeting specific performance metrics over the next three years.

1. Performance metric: Company B must achieve specific revenue targets 
2. Earnout period: Three years
3. Payment structure:

• Year 1 – if Company B achieves revenue of £20 million the sellers will receive £5 million.
• Year 2 – If Company B achieves revenue of £25 million the sellers will receive an additional £5 million.
• Year 3 – If Company B achieves revenue of £30 million the sellers will receive an additional £5 million.

The advantages of earnouts 

There are several advantages to earnouts:  

• Risk Mitigation – for buyers, earnouts mitigate risk by linking total consideration payable to future performance. If the acquired business underperforms the buyer will pay a lower price. Conversely, earnout mechanisms can include upside payments if targets are exceeded, resulting in a higher total payment to the seller.
• Incentivises Sellers – earnouts can align the interests of both parties, particularly in instances where the seller is going to remain in the business post-acquisition. An earnout incentivises the seller to ensure performance targets are met.  
• Facilitate deal negotiations – earnouts can help bridge the gap between a buyer’s and seller’s expectations of value. Sellers are often optimistic about future growth potential, whereas buyers may have a more conservative outlook. Tying part of the purchase price to the company’s future performance can bridge the expectation gap.  

The example above is very simplistic however, in reality, earnout mechanisms can be complex and it is not uncommon for disagreements to arise.

Causes of Earnout Disputes 

Earnout disputes can arise for various reasons, including: 

• Unclear share purchase agreement (SPA): Unclear or poorly defined earnout provisions in the SPA can result in opposing views on how earnout payments are achieved and calculated.  

• Manipulation of performance metrics: Individuals taking actions to artificially influence the performance metrics used to calculate earnout payments. Examples include inflating operating expenses to reduce net income or EBITDA, postponing revenue recognition to future periods, and excessively allocating shared costs from the parent company to the acquired company.   

• Financial reporting: Differing accounting standards and policies between the buyer and the seller can result in disputes over the reported figures used to calculate earnout payments.  

• Decision making: Operational decisions made by the buyer may negatively impact the performance metrics tied to the earnout. Examples include reducing marketing budgets, staff restructuring, and altering product offerings. 

Preventing Earnout Disputes 

To minimise the risk of earnout disputes arising, preventative measures can be taken, such as: 

• Clearly defined metrics and terms: Ensuring that the SPA clearly explains the earnout mechanism. Metrics should be accurately defined, with a clear method for measuring performance, and a clear timeline for achieving earnout targets. It can be helpful to include examples of how earnout payments will be calculated to avoid potential issues with interpretation. 

• Alignment of interests: Aligning the interests of all parties by ensuring that the earnout structure benefits everyone.  

• Financial reporting framework: Agreeing on the accounting standards and policies that will be used during the earnout period.  

• Decision making: Include in the SPA provisions that stipulate the operational changes that can and cannot be made during the earnout period.  

• Dispute resolution clauses: Incorporate specific dispute resolution mechanisms into the SPA to provide a clear path for resolving disputes if they arise.  

Resolving Earnout Disputes 

When earnout disputes arise it is in the best interest of all parties to resolve them as quickly as possible. Common methods for resolving earnout disputes include: 

• Mediation: An independent third party facilitates negotiations between the parties in dispute in an attempt to reach a mutually agreeable solution. Mediation has become an increasingly popular approach in recent years. It is a cost-effective tool in resolving disputes and courts look unfavourably on parties who refuse to mediate. 

• Expert determination: Expert determination involves an independent expert examining the facts and making a binding decision. This approach is ideal for resolving disputes over specific technical accounting issues related to earnout disputes. SPAs commonly contain an Expert Determination clause, which sets out the process for selecting and appointing an expert, the scope of the Expert’s work, and the conduct of the Expert.  

• Arbitration: Arbitration is a more formal process where an arbitrator makes a binding decision after reviewing evidence and hearing the arguments of both sides. It is generally faster and less costly than litigation. 

• Litigation: If other methods fail, litigation may be necessary. This approach should be a last resort due to its complexity, cost, and time-consuming nature. However, in particularly complex cases it may be necessary.  

How we can help 

Earnout mechanisms can be valuable tools in M&A transactions, aligning the interests of all parties and facilitating deal negotiations. However, they also carry risks, and disputes relating to the interpretation and implementation of earnouts can arise.  

Our M&A advisors have significant experience and expertise in advising on earnout mechanisms. We regularly: 

• assist with the drafting and structuring of earnout provisions in the SPA;  
• advise on the preparation and review of earnout accounts; 
• perform interim reviews of financial performance against earnout targets; and 
• provide dispute resolution services when earnout disputes arise. Our experts have acted in the capacity of Mediator, Expert Determiner, and Expert Witness.  

If you would like further information on the team and our experience, please do not hesitate to get in touch.