4 Tips for Drafting Earnouts To Avoid Disputes
Editor's note: Authored by Michael McMahon, Tijana Brien and Bobby Earles, this article was originally published in Law360.
Amid a somewhat sluggish mergers and acquisitions market, and as buyers seek to scoop up companies at a discount while sellers long for the sky-high valuations of 2020 and 2021, the earnout is having a moment.
In broad terms, an earnout provision is one in which a buyer agrees to pay additional consideration to a seller, after closing, if certain milestones or requirements are achieved.
The use of an earnout provision is often a way to bridge a valuation gap between buyers and sellers who otherwise want to move forward with a transaction.
Earnouts have the potential to be conceptual wins for both parties.
The earnout returns value to the seller if the target company performs at or above expectations.
It also protects downside for buyers including by incentivizing seller stakeholders to remain involved with the business post-closing and hedging against uncertainties — like future growth potential, market conditions and whether regulatory approvals will be obtained.
In addition, earnouts allow buyers to somewhat de-risk transactions.
For example, if the target claims it will achieve certain growth — i.e., three times earnings before interest, taxes, depreciation and amortization, or EBITDA, over a particular time horizon, such as two years — then the buyer can pay an amount at closing based on a more conservative growth profile, and if the target delivers on its promises, pay future consideration based on the actual growth to the business, a win for both sides.
While earnout provisions have been a staple of life sciences deals for many years, 2023 saw a dramatic uptick in the use of earnout provisions in non-life sciences deals, as recently reported by the SRS Acquiom 2024 M&A Deal Terms Study.[1]
Of the deals SRS analyzed, 33% included earnouts, up from 21% in 2022 and 18% in 2021. The use of earnout provisions in less traditional settings also has garnered media attention.
In May 2023, the Washington Commanders grabbed headlines[2] for allegedly using an earnout provision in a contract between Dan Snyder — owner of the Commanders — and the Josh Harris Group, which acquired the Commanders.
In this rumored deal, if the Commanders franchise hits specified financial benchmarks, Snyder may be entitled to receive additional payouts. As The Washington Post reported,[3] this type of earnout payment structure is extremely rare in sports franchise sales; nevertheless, it is an example of the earnout's versatility.
Predictably, as earnouts have become more prevalent, the number of post-closing disputes over earnouts also has increased.
For example, based on the admittedly inexact science of searching court dockets, Bloomberg[4] reported that, in the first quarter of 2023, the number of earnout disputes filed in the Delaware Court of Chancery quadrupled to roughly the same number of similar disputes filed during the same period in the prior year.
Because many earnout disputes are decided in private proceedings by subject matter experts engaged by the parties, it is likely that the occurrence of disputes is considerably greater than these numbers suggest.
Avoiding Common Pitfalls in Earnout Provisions
Although an earnout can help to bridge the valuation gap between buyers and sellers, in many cases, earnouts may simply delay an inevitable dispute.
Indeed, Vice Chancellor J. Travis Laster of the Delaware Court of Chancery astutely observed 15 years ago in the Airborne Health Inc. v. Squid Soap decision, that "an earn-out often converts today's disagreement over price into tomorrow's litigation over the outcome."[5]
Not much has changed in the intervening decade and a half. If not given appropriate care and attention, earnout provisions can lead to insurmountable differences in interpretation on whether the earnout metrics have been met.
Further complicating matters, earnout disputes are often referred to independent subject matter experts chosen by the parties, and not courts. This is typically intended as a means of efficiently expediting resolution, but disputes often arise regarding the dispute resolution process itself. Accordingly, buyers and sellers alike should exercise caution when drafting earnout provisions.
Below, we provide a few considerations.
Tip 1: Use clear and unambiguous terms.
Clear drafting of the earnout terms is crucial. Often, earnouts are crafted with bespoke terms that leave much room for subjective interpretation.
Parties should give considerable thought to how key terms and phrases are defined, and they should set clear metrics and goals that ideally can be objectively measured — including EBITDA or net revenue targets, sales targets, regulatory approvals, study or clinical trial completion.
An illustrative example, such as an EBITDA calculation for an earnout based on achievement of certain EBITDA metrics, appended to the agreement also can provide helpful clarity for demonstrating how the parties intended the earnout to function.
Additionally, parties should plainly spell out timing mechanisms, such as for when regulatory or financial milestones must be reached, and what rights, if any, sellers have to access information buyers used to prepare earnout statements or make business decisions that affect the earnout.
Given that earnouts often tend to be crafted for specific deals, situations and parties, drafters should take care not to repurpose earnout terms from other deals without careful consideration.
Tip 2: Explicitly define methods to measure "efforts" provisions.
Drafters should clarify whether the buyer has an obligation to operate the acquired business in such a way as to maximize the earnout opportunity for the benefit of the seller. However, inclusion of so-called best efforts or commercially reasonable efforts clause, without further detail or definition, can lead to uncertainty.
In the Delaware Chancery's 2022 decision in Menn v. ConMed Corp., for example, the contract between the buyer and seller included a "commercial best efforts" provision.[6] While some "commercial best efforts" clauses contain what is called a contractual yardstick — a method to measure the efforts — the contract in Menn lacked any express standard by which to gauge the buyer's efforts.
The court turned to other sources of interpretation for best efforts and found that, in that context, "commercial best efforts" required "a party to do essentially everything in its power to fulfill its obligation."
The Menn case should serve as a warning to buyers to build guardrails into earnout provisions around how they will be expected to manage the business post-closing, such as whether they must retain certain employees; continue past practices, including discounts and training; and fund future improvements or development.
Tip 3: Set strict timelines for resolving disputes.
Parties to a deal often build dispute resolution provisions directly into the earnout with the hope of quickly and cheaply resolving disputes and avoiding costly in-court litigation. While alternative dispute resolution, such as referring disputes to a subject matter expert, can be efficient, that is not always the case.
To avoid these pitfalls, earnout provisions should set clear, strict timelines by which a dispute should be resolved. For example, if the parties want the dispute resolved within 90 days from the time it arises, the agreement should say so.
Otherwise, it is not uncommon for parties to take months to simply agree upon and engage the private subject matter expert to adjudicate the matter, and that timeline can drag on for longer if there are conflicts to work around.
Even once the process gets rolling, there may be many more months of costly submissions, rebuttals, and perhaps even oral argument or evidentiary proceedings. If the parties want, need or intend the process to be completed faster, they should say so.
Similarly, the earnout provision should state exactly what triggers escalation of the dispute; the parties should not have to litigate over whether a dispute is ripe for referral to the expert or court.
Tip 4: Clearly define what types of disputes will go to an expert.
If the parties plan on sending any disputes to a subject matter expert, like an independent accountant, they should clearly spell out who the expert will be and who the backup will be if that individual or firm is conflicted.
The provision also should make clear what sorts of disputes the expert has jurisdiction over.
Take, for example, the 2022 Bus Air LLC v. Woods decision in the U.S. District Court for the District of Delaware.[7] There, the buyer and seller questioned whether there was an agreement to submit to arbitration in the case of an earnout dispute.
The seller brought counterclaims relating to the earnout, and the buyer moved to compel arbitration. The court denied the buyer's motion and found the parties had not clearly expressed their intent in the purchase agreement to arbitrate all earnout disputes.
Parties can avoid this uncertainty by addressing specifically the types and scope of disputes an expert will have jurisdiction over, and which disputes otherwise must go to court.
For example, if an accounting expert will only be able to resolve disputes over revenue calculations relating to the earnout, but will not have authority to resolve other disputes between the parties, such as whether the buyer used commercial best efforts to run the business, the agreement should state clearly that the expert will be serving as an expert and not an arbitrator.
Conclusion
With care and precision, earnout provisions can be effective tools and help buyers and sellers agree to a deal value — or account for situations where the future performance of the target is simply uncertain.
Before using an earnout provision, however, the parties need to consider the potential for a later dispute. Many such disputes can be avoided with patience and careful drafting, and thus often there is no need to put off to tomorrow what can be resolved today.
[1] https://www.srsacquiom.com/our-insights/deal-terms-study/.
[3] https://www.washingtonpost.com/sports/2023/05/17/josh-harris-deal-earnout-commanders//
[4] Abena Opong-Fosu, "Earnouts Are Showing Up in More M&A Deals — and Lawsuits," Bloomberg Law, June 23, 2023. https://news.bloomberglaw.com/bloomberg-law-analysis/analysis-earnouts-are-showing-up-in-more-m-a-deals-and-lawsuits.
[5] Airborne Health, Inc. v. Squid Soap, LP, 984 A.2d 126, 132 (Del. Ch. 2009).
[6] Menn v. ConMed Corp., No. CV 2017-0137-KSJM, 2022 WL 2387802 (Del. Ch. June 30, 2022), judgment entered, (Del. Ch. 2022).
[7] Bus Air, LLC v. Woods, No. CV 19-1435-RGA-CJB, 2022 WL 2666001 (D. Del. July 11, 2022).
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