Key Points:

You should consider the scope and nature of the information to be disclosed to calculate an entitlement to payment under an earn-out – and then document it.

Earn-outs are often used where there is uncertainty about the performance of a target business post-completion, and a buyer (particularly one which may not have the expertise to run the business) wants to give one or more sellers, who will remain with the business, an incentive to achieve certain results. Given their role, how an earn-out is calculated is very important - the earn-out provisions should be sufficiently detailed to avoid disputes.

The problem is that, even if an implied term regarding earn-out information might seem appropriate, it can be very difficult to imply that term into a contract, especially if the contract is detailed and a result of extensive negotiations – as parties recently discovered in the Federal Court (Barnes v Forty Two International Pty Limited [2014] FCAFC 152).

Earn-outs and the licence fee

Mr Barnes and Mr Hawksley agreed to sell shares in Forty Two (and a related company) to BlueFreeway Ltd. The purchase price was payable in tranches, including two payments calculated by reference to earnings before interest and tax (EBIT) targets for the sale companies for nominated financial years. Mr Barnes and Mr Hawksley were to remain directors of Forty Two after completion and the sale documentation contained detailed provisions regarding the calculation of the EBIT results and the reporting of financial information by the sellers and BlueFreeway in this respect.

After completion, Mr Barnes and Mr Hawksley negotiated a licence for Forty Two which resulted in it receiving a significant fee from a third party licensee. This had a positive effect on EBIT and so would increase the payments to be made to Mr Barnes and Mr Hawksley under the sale. The licensee struggled to obtain funding to pay the licence fee, so Mr Barnes and Mr Hawksley helped procure the necessary financing by personally guaranteeing a loan.

Mr Barnes and Mr Hawksley then decided to leave the business and received payments based on Forty Two's EBIT (which included the receipt of the licence fee).

The dispute turns into litigation

At trial, BlueFreeway successfully argued that the failure of Mr Barnes and Mr Hawksley to disclose their role in assisting with the funding of the licence fee breached an implied term of that agreement. The implied term was that Mr Barnes and Mr Hawksley would disclose to BlueFreeway "all information known to them which might become relevant to the [EBIT] calculation". BlueFreeway also successfully argued that it had lost an opportunity to negotiate the exit arrangements with Mr Barnes and Mr Hawksley with knowledge of their role in procuring the finance for the licence fee.

The trial judge decided, amongst other things, that the implied term was necessary, that it filled a gap in the sale documents regarding the reporting obligations for the EBIT calculation and that, if the term was proposed in negotiations, it would have been documented by the parties.

The Full Court disagreed, allowing the appeal from Mr Barnes and Mr Hawksley. Amongst other things, the Court said that:

  • the proposed term was not necessary to give business efficacy, nor was it obvious – the sale agreement contained a number of detailed provisions that dealt with the provision of financial information to and from BlueFreeway for the calculation of the EBIT. Essentially, the sale agreement operated effectively without the implied term; and
  • the proposed term was unclear and oppressively broad – what does information known to the sellers which "might become relevant" to the calculation of the EBIT actually mean?

Be clear about disclosure obligations

In the case of earn-out provisions where, as was the case here, the sellers remain with the business after completion and the exchange of information is critical, parties should consider the scope and nature of the information required to be disclosed to calculate an entitlement to payment. A similar comment applies in relation to other post-completion payments - the scope and nature of the information used to calculate those payments should also be appropriately set out.

Parties should expressly document these arrangements in reasonable detail, and it is particularly important for parties to be aware that while an implied term may seem appropriate, there is a high bar to be cleared before any such term will be implied. This is particularly the case where the relevant contract is detailed and was the subject of extensive negotiations involving legal advisers.