The price payable on the sale of a company often includes an element of "earnout", making the price dependent on performance. The Court of Appeal has made clear that a requirement that this is based on audited accounts will be strictly enforced, and separate audited accounts will be required if the company has changed its accounting date so that it has ordinary audited accounts which do not match the requirements of the earnout clause.

As is in many company purchase transactions, the vendor in Treatt plc v Barratt [2015] EWCA Civ 116 agreed to an earnout clause under which part of the price was to be calculated by reference to the average profit for the two years following acquisition "as shown in the audited accounts… for the two calendar years ending 31 December 2011".

As also often happens, following the acquisition the target changed its accounting year and audited accounts were  prepared for the  following two  years on that basis. It followed, therefore, that audited accounts were not prepared for the years ending 31 December. When the buyer presented its earnout notice specifying what it claimed to be the additional payment due under the earnout clause, it did so on the basis of an approximation derived from the audited accounts. The seller rejected that notice and claimed it was invalid because it was not supported by audited accounts. The buyer referred in turn to a dispute resolution provision under which an accountant would be appointed to act as expert (not an arbitrator) to resolve any disputes  arising from the earnout notice. This clause, the buyer said, provided a mechanism for correction of any defects in its notice.

The Court of Appeal unanimously took the view that the requirement for the earnout notice to be calculated on the basis of audited accounts for the periods agreed provided an important protection for the vendors, giving the assurance both of professional independence and preparation in accordance with appropriate accounting policies and standards.

The Court of Appeal also dismissed the suggestion that the expert accountant clause could save the notice. It took the view that the suggestion that the expert could make good any deficiencies was "a recipe the difficulty and expense": it would deprive the parties of the opportunity to identify what was really in dispute. In the view of the Court of Appeal an expert faced with this task would either have to order that a fresh audit was undertaken or undertake an audit himself; both suggestions were viewed as sufficiently impractical to make it unlikely that that was what the parties had agreed (although it is a solution strikingly similar to what appears to have been the result in this case, as explained below).

Finally, the Court of Appeal decided that in these circumstances the earnout notice was a complete nullity, although it was said that had there been a genuine attempt to comply with the requirements of the clause, and mere error would not have had this Draconian effect.

Unfortunately, the report does not state what happened next. Clause 3.3 of the earnout provision stated that if an earnout notice had not been served within 30 days of the relevant date, the notice would be deemed served and the expert clause would operate to set the price. This is, in effect, what the buyers said should have been done with their notice but which the Court of Appeal said was wholly impractical and could not have been agreed.

In light of this Court of Appeal decision, a buyer that has agreed to an earnout provision like this will need to factor into the cost effectiveness of any change to its accounting year end and the possibility that it will need to pay for a separate audit to comply with the earnout provision.