An earn-out is a tool that buyers and sellers use from time to time in M&A transactions to defer the payment of a portion of the purchase price until after the closing upon the achievement of certain performance targets or the happening of certain deﬁned events. Earn-outs can be a useful tool when buyers and sellers cannot agree on the value of the business being sold or its future performance. Earn-outs oﬀer the potential to bridge the valuation gap between what a seller thinks the business is worth and how it will perform going forward and what the buyer perceives the value of the business (and its future growth prospects) to be. Where the seller will remain involved in the business after the closing, earn-outs can also be a useful tool to align the interests of the parties, meaning that the prospect of a potential earn-out will incentivize the seller to continue growing the business for the beneﬁt of the buyer after the closing. However, because earn-outs are inherently conditional in nature and dependent on a number of variables, some of which are outside the control of the parties, drafting and negotiating earn-outs can be complex and become the source of disputes between the parties after the closing.
This article is intended to highlight (i) some of the potential advantages and disadvantages that earn-outs present for buyers and sellers, (ii) some notable structural issues and considerations that parties should bear in mind when formulating an earn-out, and (iii) two recent Delaware court decisions that underline the importance of careful drafting of postclosing operating covenants relating to earn-out provisions in acquisition agreements.
Advantages and Disadvantages for Sellers and Buyers
From a seller’s point of view, an earn-out oﬀers the possibility of receiving a higher purchase price than a buyer would otherwise be willing to pay at the closing. An earn-out also provides a seller with the chance to participate in the future success of the business following the closing if certain deﬁned performance targets are achieved. On the other hand, agreeing to an earn-out may require a seller to remain involved or invested in the business that it wants to sell, preventing a clean break from the business. A seller may also have to rely on the buyer to operate the business after the closing in a manner that results in the earn-out targets being achieved, thereby losing a measure of control over whether and to what extent the earn-out will be payable. As a result, a seller may attempt to include aﬃrmative covenants in the acquisition agreement that require the buyer to operate the business in a certain manner after the closing or that restricts the buyer from making signiﬁcant changes to the business after the closing. Even here, however, there are circumstances that a seller may not be able to predict and draft for or that arise after the closing that are outside of the control of even the buyer that may result in the earn-out not being achieved.
For a buyer, an earn-out allows the buyer to defer payment of a part of the purchase price until after the closing and oﬀers a buyer some protection against overpaying for a business. If the business is not as proﬁtable after the closing as the seller and buyer think it will be or the business does not otherwise meet certain agreed performance targets following the closing, depending on how the earn-out provision is drafted, the buyer may not be required to pay the seller any of the earn-out amount or only a reduced portion of the earnout amount. On the other hand, the presence of post-closing contractual covenants and restrictions in the acquisition agreement may limit the ﬂexibility of the buyer to operate the business it just acquired in a manner it might otherwise in the absence of the earn-out provision. In some instances, the selling stockholder may stay on as part of the management team after the closing, which has the potential to create a conﬂict of interest between the selling stockholder and the buyer. For example, the selling stockholder may want to take certain actions in the near term that have the eﬀect of maximizing proﬁts and increasing the earn-out payment, but the buyer may view such short term actions as not being in the best interests of the acquired business or its other businesses in the long term.
Earn-out provisions are typically incorporated as part of the acquisition agreement and can vary considerably based on the business being sold and the commercial agreement reached by the parties as to the form and substance of an earn-out. There are many issues that need to be considered and addressed when formulating an earn-out, including among others, the accounting and tax treatment of earn-outs, which are beyond the scope of this article. From a structural point of view, there are several key issues and considerations that buyers and sellers should always bear in mind when drafting any earn-out provision.
Deﬁning the Earn-Out Target
Earn-out performance targets that give rise to the payment of the earn-out should be clearly deﬁned and properly align the parties’ interests. Most performance targets are based on ﬁnancial targets. Examples of common ﬁnancial targets include performance targets based on revenue, net income or EBITDA. A seller and buyer may have diﬀerent preferences when selecting ﬁnancial performance targets. For example, a seller may prefer a target based on revenues because costs and expenses have less of an impact. On the other hand, a buyer may not like a target based on revenues because if the seller remains involved in the operation of the business after the closing, a revenue based target will not incentivize the seller to control its costs and expenses. Frequently, buyers and sellers will agree on an EBITDA-based target, particularly where the purchase price was based on a multiple of EBITDA, because EBITDA takes into account operational costs and expenses but excludes non-operational items such as interest, tax, depreciation and amortization. A seller may continue to have concerns with a buyer’s ability to manipulate earnings after the closing by making more expenditures in the short term during the earn-out period and thereby reducing earnings and ultimately the earn-out payment. This concern may be addressed by capping the amount of expenditures that the buyer makes during the earn-out period for purposes of the earn-out calculation or by drafting other speciﬁc post-closing operational covenants that address the manner in which the parties expect the business will be operated during the postclosing earn-out period.
In addition to ﬁnancial-based performance targets, earnouts may also be tied to non-ﬁnancial performance targets or milestones. For example, the entry into a new contract or the renewal of certain key contracts, obtaining a minimum number of new customers, or the favorable resolution of a pending litigation matter may all result in increased earnings power and proﬁtability for the business and trigger an earn-out payment. Operational performance targets are sometimes easier to structure and negotiate because they tend to be easier to deﬁne, in the common interest of each party and generally outside the direct control of the parties. Even here, however, the devil can be found in the details so the parties should think carefully about the parameters of such non-ﬁnancial performance targets or milestones. For example, is the earn-out period long enough to allow suf- ﬁcient time for the operational performance milestone to be achieved? Should the buyer be contractually obligated to take any speciﬁc actions in connection with achieving the operational performance target? If the parties know that certain actions must be taken in order to achieve a performance target, a seller should negotiate for express language in the acquisition agreement to address the matter rather than rely on the buyer’s implied covenant of good faith and fair dealing, at least where the acquisition agreement is governed by Delaware law.
Calculation of the Earn-Out Target and Dispute Resolution
The acquisition agreement should also clearly set forth how the parties will determine whether and to what extent the performance targets have been achieved and how disputes will be resolved. The mechanics for determining whether non- ﬁnancial performance targets have been achieved tend to be somewhat simpler to document since generally speaking, it will usually just involve providing evidence that the speciﬁed non-ﬁnancial performance target event has occurred. In contrast, the mechanics for determining whether ﬁnancial performance targets have been achieved tend to be more complicated since ﬁnancial statements and calculations will need to be prepared in order to determine whether the ﬁnancial targets giving rise to an earn-out payment have been met. A buyer will usually prepare the initial ﬁnancial statements and calculations for an earn-out since it will be in control of the business following the closing. The earn-out should provide the seller with an opportunity to review and dispute the buyer’s ﬁnancial statements and calculations. In this regard, it is important for both parties to carefully consider and specify what accounting principles will be used when preparing the ﬁnancial statements and calculations in order to minimize future disputes when the calculations are made.
The acquisition agreement should address how disputes will be resolved. In the case of an earn-out based on ﬁnancial targets, it is usually heard by an independent accountant selected by the parties and may be similar in nature to dispute resolution procedures that are frequently incorporated into acquisition agreements for resolving post-closing purchase price adjustments based on working capital or other ﬁnancial metrics. Common considerations in drafting a dispute resolution provision include, among others, (i) how the independent accountant will be selected; (ii) the scope of the independent accountant’s authority (e.g., can the accountant apply a different methodology from the one used by the parties; can the accountant decide on issues not raised by the parties; can the accountant decide on its own ﬁgure or must it choose between the ﬁgures proposed by the parties); (iii) the allocation of the independent accountant’s costs and expenses; and (iv) the timing for payment of any amounts not in dispute.
The Length of the Earn-Out Period
The length of the post-closing earn-out period will vary depending on the performance target chosen and can be a point on which a seller and buyer have competing interests.
Earn-out periods may range from one year or less following the closing to several years after the closing. For sellers, depending on the performance target and its outlook, they may prefer a short earn-out period so that they can receive their earn-out payment as quickly as possible. This will reduce the amount of time that a seller is eﬀectively providing the buyer with interest free ﬁnancing for the purchase of the business and also mitigate against the risk that intervening events occur after the closing that adversely aﬀect the creditworthiness of the buyer. On the other hand, some sellers may prefer a longer earn-out period to ensure that they have suﬃcient time to achieve the earn-out target and maximize the earnout payment.
A buyer may also have conﬂicting interests to consider when evaluating the duration of the earn-out period. On the one hand, a buyer may prefer a shorter earn-out period so that it is not indeﬁnitely subject to a contingent payment obligation and related post-closing operating restrictions that limit its ﬂexibility to operate the business. On the other hand, some buyers may prefer a longer earn-out period to make sure that the performance of the business is not ﬂeeting but rather sustainable over the longer term. Where the seller stays on to manage the business post-closing, a buyer may prefer a longer earn-out period to ensure that strong performance in the ﬁrst year following closing is not an aberration manufactured by the seller taking short term actions that will negatively impact the business in the long run.
The Nature of the Earn-Out Payment The nature of the earn-out payment itself may range from a ﬂat speciﬁed amount, a multiple of the amount by which the business exceeds the earn-out target, another agreed formula or even payment in the form of buyer’s stock. If a formula is used to determine the earn-out payment, a buyer will likely want to cap the earn-out amount and a seller will likely want to set a minimum ﬂoor amount that it will receive. A seller should also consider whether a creditworthy guaranty should be provided in order to secure the buyer’s contingent obligation to pay the earn-out, particularly where the buyer acquired the seller’s business through a leveraged buyout resulting in the pledge of the assets of the business to the lenders that ﬁnanced the purchase price.
The Timing of Earn-Out Payments
Where the earn-out period is shorter (e.g., one year or less), there may just be one payment at the end of the earn-out period. In other instances where earn-out periods extend for a number of years, multiple earn-out payments may be contemplated and measured, for example, on an annual basis during the earn-out period. With earn-out periods that extend over a number of years, a buyer may negotiate for a claw back right where an earn-out payment is earned in one year by the seller but there is a shortfall in a subsequent year or years during the earn-out period. To facilitate a claw back, a buyer may even seek to deposit any earn-out payments that are achieved during one year of an earn-out period with an independent escrow agent in order to secure against the possibility of shortfalls during subsequent time periods during the earn-out period. Conversely, a seller may negotiate for the right to receive all or a portion of the earn-out payment where, for example, there is a shortfall in the ﬁnancial performance target during one year, but the ﬁnancial performance target is exceeded during other years of the earn-out period. The timing of earn-out payments may also depend on whether the parties negotiate for buy-out options, acceleration provisions or setoﬀ rights. A buyer may seek a buyout option for itself, which gives it the ﬂexibility to pay a speciﬁed amount to satisfy the earn-out obligation early, in order to free itself from restrictive covenants or any rights the seller may have to consent to certain actions (e.g., a sale of the business by the buyer). Similarly, a seller should consider whether the timing for earn-out payments should be accelerated where certain events occur after the closing (e.g., sale of the business; breach of post-closing buyer covenants; buyer insolvency). Another consideration for a buyer that may impact its view of the timing of the earn-out obligation is whether the buyer will attempt to make the earn-out obligation subject to oﬀset on account of indemniﬁcation claims that may arise after the closing against the seller.
Recent Delaware Court Decisions
Two recent Delaware court decisions highlight the importance of considering the inclusion of express post-closing operating covenants related to earn-outs in acquisition agreements governed by Delaware law.
In Winshall v. Viacom International Inc., 76 A.3d 808 (Del. 2013), the Delaware Supreme Court upheld the dismissal by the Court of Chancery of a complaint over the payment of an earn-out in which Walter Winshall, as a representative of the selling shareholders, argued that after the acquisition of Harmonix Music Systems, Inc. (“Harmonix”) by Viacom International, Inc. (“Viacom”) pursuant to a merger agreement, Viacom breached its implied obligation of good faith and fair dealing under the merger agreement by intentionally not taking advantage of an opportunity to negotiate lower distributions fees under a distribution agreement with Electronic Arts, Inc. (“EA”), which would have resulted in an increased earn-out payment to the selling shareholders.
Under the merger agreement, the selling shareholders were entitled to a contingent right to receive incremental uncapped earn-out payments based on Harmonix’s ﬁnancial performance during the two years after the merger (i.e., 2007 and 2008). The selling shareholders’ earn-out payments were equal to 3.5 times the amount by which Harmonix’s gross proﬁt exceeded $32 million in 2007 and $45 million in 2008. The distribution fees payable by Harmonix to EA under the distribution agreement had the eﬀect of reducing gross proﬁts for purposes of the earn-out formula. Notably, the merger agreement did not require Viacom or Harmonix to conduct their businesses following the merger so as to ensure or maximize the earn-out payments. During a renegotiation of the distribution agreement with EA after the merger, EA oﬀered to reduce the 2008 distribution fees in exchange for other beneﬁts, but ultimately Viacom did not accept that proposal and instead left the 2008 distribution fee level unchanged and reduced the distributions fees for years beginning in 2009 in exchange for certain other beneﬁts. While it is true that the selling shareholders’ earn-out payment may have increased had the 2008 distribution fees been reduced as part of the renegotiations between Viacom and EA, the court explained that “none of those amendments [that Viacom entered into with EA in respect of the distribution agreement] aﬀected in any way the Selling Shareholders’ earn-out payment for 2008: the amount of that payment remained exactly what it would have been under the Original EA Agreement.”
Plaintiﬀ argued that when the opportunity to increase the amount of the selling shareholders’ 2008 earn-out payments was presented, Harmonix had an obligation implied under the merger agreement to take that opportunity, but the court rejected the plaintiﬀ’s argument and explained that “[t]he implied covenant of good faith and fair dealing cannot properly be applied to give the plaintiﬀs contractual protections that ‘they failed to secure for themselves at the bargaining table.’” The court in Winshall concluded that Winshall’s claim rested on a fundamental misconception of the limited scope and function of the implied covenant of good faith and fair dealing in Delaware contract jurisprudence. In aﬃrming the decision of the Court of Chancery, the court in Winshall cited several passages from the Court of Chancery’s decision that are instructive:
[T]he implied covenant is not a license to rewrite contractual language just because the plaintiﬀ failed to negotiate for protections that, in hindsight, would have made the contract a better deal. Rather, a party may only invoke the protections of the covenant when it is clear from the underlying contract that “the contracting parties would have agreed to proscribe the act later complained of … had they thought to negotiate with respect to that matter.
[T]here is a critical diﬀerence between Viacom and Harmonix’s actions here and the actions of an acquirer who promises earn-out payments to the sellers of the target business and then purposefully pushes revenues out of the earn-out period. It is true that when a contract confers discretion on one party, the implied covenant of good faith and fair dealing requires that the discretion — such as Viacom’s discretion in controlling Harmonix after the Merger and during the earn-out period — be used reasonably and in good faith. Thus … if Viacom and Harmonix had agreed to pay double EA’s ask in distribution fees in 2008 in return for paying no distribution fees in 2009, such an agreement would arguably be a breach of the implied covenant. In that case, Viacom and Harmonix would be depriving the Selling Stockholders of their reasonable expectations under the Merger Agreement by actively shifting costs into the earn-out period that had no place there…. Winshall would have me hold that [Viacom’s] discretion over the Harmonix business … was subject to an implied covenant of good faith that encompassed not only a duty not to harm the Harmonix business so as to reduce Gross Proﬁt for purposes of calculating the earn-outs, but also to do everything it could to increase the earn-out payments. As Viacom and Harmonix point out, “on [Winshall’s] logic, Defendants would have been obligated to negotiate the distribution fees down to zero for 2008 to maximize the impact on the [earn-out payment for 2008] and make up the shortfall with higher payments thereafter—a commercially absurd outcome.” This is not a tenable application of the limited implied covenant of good faith and fair dealing.
More recently, in American Capital Acquisition Partners, LLC v. LPL Holdings, Inc., 2014 WL 354496 (Del. Ch. Feb. 3, 2014), the Delaware Court of Chancery heard a dispute over an earn-out provision in a stock purchase agreement in which the plaintiﬀ seller argued that the buyer was obligated under the implied covenant of good faith and fair dealing to make certain technical adaptations that would have resulted in the satisfaction of certain “gross margin” thresholds necessary for triggering the payment of a contingent earn-out. The parties anticipated and discussed the need for certain technical adaptations to be made to the buyer’s computer-based systems prior to signing the stock purchase agreement, but the stock purchase agreement did not include any express language obligating the buyer to make, or even use any eﬀorts to make, any such technical adaptations to allow the acquired business to meet the contingent purchase price earn-out targets. The plaintiﬀ seller argued that notwithstanding the absence of express language requiring such technical adaptations, the existence of the contingent earn-out itself in the stock purchase agreement imposed an obligation on the buyer under the implied covenant of good faith and fair dealing to make the technical adaptations because the parties recognized that, absent those adaptations, there would be insuﬃcient revenue to achieve the contingent purchase price earn-out targets.
The defendant buyer argued that the implied covenant of good faith and fair dealing only serves a gap-ﬁlling function that is implicated when an issue arises after the stock purchase agreement is signed that was not anticipated when the parties negotiated and signed the stock purchase agreement. If the issue, which in this case centered around the need for certain technical adaptations, was known and the parties chose not to draft for it in the stock purchase agreement, the implied covenant should not be used to impose a new obligation on the buyer that could have been negotiated for and included in the stock purchase agreement but was not included.
The court in American Capital Acquisition Partners agreed with the buyer’s interpretation of the implied covenant of good faith and fair dealing. The court concluded that the technical adaptations that the plaintiﬀ seller wanted the buyer to make were understood by the parties to be necessary before the stock purchase agreement was signed, but the parties did not draft any language into the stock purchase agreement to obligate the buyer to make such adaptations. As a result, the implied covenant’s gap-ﬁlling function could not make up for that omission.
In contrast, the court in American Capital Acquisition Partners did ﬁnd an inference that the defendant buyer had breached its implied covenant of good faith and fair dealing in connection with certain other aﬃrmative actions that the buyer took in order to minimize its earn-out payments to the seller. For example, the seller argued, and the court agreed, that the buyer had breached the implied covenant of good faith and fair dealing by intentionally shifting sales and resources (e.g., customers and employees) away from the target company to a separate wholly owned subsidiary of the buyer in order to depress revenues and avoid paying the additional contingent purchase price. With respect to these aﬃrmative actions that the buyer took, the court concluded that those actions had not been anticipated by the parties at the time of signing the stock purchase agreement and therefore the implied covenant of good faith and fair dealing could be used as a basis to claim that the buyer’s taking of those aﬃrmative actions constituted a breach of its implied covenant of good faith and fair dealing.
There are several key points that sellers and buyers may take away from these recent Delaware court decisions when considering whether to include, and how to draft, post-closing earn-out covenants in acquisition agreements:
- While the recent Delaware court decisions may be read to hold in relevant part that the implied covenant of good faith and fair dealing may bar a buyer from taking aﬃrmative actions to reduce or avoid a contingent earn-out payment, the implied covenant of good faith and fair dealing does not require a buyer to maximize a contingent earn-out payment.
- As the implied covenant of good faith and fair dealing, at least in Delaware, only provides a limited measure of protection for sellers in the context of earn-outs, whenever possible, sellers should try not to leave the issue of postclosing earn-out covenants entirely silent. Possible formulations may include a requirement that the buyer act in good faith and avoid taking any actions intended to prevent or inhibit the achievement of the earn-out payment or an af- ﬁrmative covenant that the buyer will use some level of eﬀort (e.g., commercially reasonable eﬀorts) to achieve the earn-out targets.
- If there are any particular actions that the parties have discussed or anticipate will need to be taken in connection with achieving an earn-out, sellers should negotiate for express post-closing covenants to address any such anticipated actions rather than rely on the implied covenant of good faith and fair dealing. At least in Delaware, the implied covenant of good faith and fair dealing cannot be used to create new obligations where the issue in question was known by the parties and they chose not to draft for it.
- If the chosen governing law of the acquisition agreement is not Delaware, the parties and their counsel should consider whether the chosen governing law jurisdiction has addressed this issue and taken a view that is similar to or diﬀerent from Delaware.