The earnout provision: A tool for mitigation, or a path to litigation?
When a transaction’s parties cannot agree on a purchase price prior to closing, or when buyer financing is constrained, the difference between the parties’ views on value or the disparity between the purchase price and available financing is often bridged with an earnout-adjustment provision. These adjustments are legally binding contracts where a portion of the purchase price expected to be paid in the future is contingent on the sold company achieving financial or operational targets.
However, organizations must consider both direct and tangential complexities that can arise in an earnout-adjustment provision. For example, some agreements call for the buyer to pay a percentage of the amount that the sold company’s performance is equal to or greater than the target, while others set a defined dollar amount payable when a specific threshold is reached. Payments may be structured as a lump sum, staggered or on a sliding scale.
These variables, as well as calculation of earnout targets, treatment of expenses and revenues, and results of management decisions following closing are often the subject of earnout litigation. Mitigating these risks can be achieved with provisions with specific guidelines, well-defined obligations and definitive details about how earnouts should be calculated.
An earnout should be defined and measurable, reflective of the sold company’s operating characteristics and not subject to manipulation. Identifying the amount requires a balancing of the incentives created and option-like characteristics of the earnout. The term should correspond with the period required to identify the value of the sold company, and where the buyer wishes to incentivize management.
Read a recent article published in the American Bankruptcy Institute’s ABI Journal from RSM US LLP’s Boris Steffen to understand how earnout litigation can affect the value of a bankruptcy estate, as well as how to choose financial targets and structure payments, and where common areas of dispute may arise.