Negotiating Success: Mastering Earnout Agreements
With earnouts making their mark in an impressive 21 percent of M&A deals in 2022, these elusive chameleons of the M&A realm delicately balance optimism and frustration. These complex arrangements resulted in a surge in the number of disputes in the first quarter of 2023, 44 of which found their way to the Delaware Chancery Court. An earnout is a “contractual mechanism in a merger or acquisition agreement, which provides for contingent additional payments from a buyer of a company to the seller’s shareholders.” A pertinent question that often arises in the midst of these negotiations is why the buyer should pay an additional amount for the deal. This additional amount serves to bridge the gap in purchase price when buyers and sellers cannot reach an agreement and is “earned” once the targets are achieved.
The world of earnout agreements is a complex landscape seen from different angles by buyers and sellers. For buyers, earnouts offer a strategic edge. They create a direct link between the acquisition price and the actual performance of the selling company, reducing the risk of overpaying and keeping the seller’s team motivated post-acquisition. Sellers, on the other hand, approach earnouts with caution. They grapple with questions about whether the targets are realistic, decisions over financial metrics, and how they can maximize their earnout potential. For sellers, especially those with a limited trading history, earnouts can be a crucial tool for closing the valuation gap with the buyer. This intricate dance between buyers and sellers highlights the importance of well-thought-out agreements in earnout scenarios.
While earnouts may seem like a reasonable compromise, the more frequently earnouts are utilized to resolve pricing disputes, the more intricate and complex they tend to become. The following section outlines some of the major issues with earnout provisions, namely, problems with accounting metrics, post-closing operational continuity, and questions surrounding implicit good faith.
The issue at the forefront of any earnout dispute is the calculation metric. The calculation metric is not one singular concept, but rather an amalgamation of smaller and more intricate financial concepts. The issue in deciding the accounting metric is that one concept can be interpreted differently, resulting in inconsistent answers. This issue is especially pertinent when calculating EBITDA. For instance, Company A may include depreciation and amortization in their EBITDA calculation, viewing them as non-cash expenses, whereas Company B may exclude all operating expenses, including depreciation and amortization. This leads to a substantial gap in their valuation of the target company, with Company A valuing their earnings at $30 million and Company B at $50 million. The differing interpretations of EBITDA create challenges in negotiations, emphasizing the need for alignment in financial metrics during such discussions. Moreover, financial metrics can be influenced by market conditions, as seen during the 2008 financial crisis. Lastly, complex formulas often result in errors and costly disputes.
Post-Closing Operational Continuity
The most common dispute over earnouts is the buyer’s obligation to increase the earnout. During the earnout period, buyers are typically bound by commitments to operate the acquired business with good faith and fair dealing, in a manner consistent with past practice, and under specific covenants. When evaluating the success or failure of an earnout, parties often turn to these operational covenants and attempt to make a case for a breach. Notably, Delaware generally upholds the principle that buyers have no obligation to take or abstain from specific actions and are not implicitly obliged to make maximal efforts to achieve an earnout. Courts have clarified that buyers cannot actively impede the attainment of earnout targets, as this would violate the implied covenant of good faith and fair dealing, but legitimate business decisions are not considered violations. For instance, in Fireman v. News America Marketing In-Store, Inc., the buyer’s decisions to rebrand the seller’s business products, remove the top level managers, and not use the seller’s marketing resources were held to be fair business decisions that did not violate good faith. Decisions on such issues become even more complicated when the business structures are complex and functional departments are tightly integrated.
Narrow Interpretation of Implied Covenant
In Delaware, the covenant of good faith and fair dealing is an implied covenant to an earnout agreement. Many jurisdictions deal with this implied covenant in different ways. The way the courts generally deal with this implied covenant is to apply it strictly, especially the New York courts, thus making it very narrow in reach. The court provides no room to read between the lines. Good faith only means the welfare of either the seller or, sometimes, both the buyer and seller. Compared to some foreign jurisdictions, like India, where some room is given to read into good faith and other standstill covenants, the result is significant. A narrow interpretation of the implied covenant of good faith in an earnout decision can strip sellers of protection and spark disputes, damaging trust and potentially impacting future transactions.
In the realm of earnout agreements, buyers should consider engaging third-party accountants for payment calculations, thereby reducing dependence on the seller’s assessment. It is vital for both parties to weigh the benefits and costs of earnouts when closing minor valuation gaps which could be approached more pragmatically. Opting for shorter earnout periods can mitigate dispute risks, streamline the process, and minimize expenses and uncertainties. Instead of relying on implicit good faith, parties should incorporate protective clauses into contracts. Ultimately, the key to success lies in drafting precise, business-specific earnout provisions during M&A negotiations, but striking the right balance between foresight and detailed drafting remains a challenge. The fundamental question shall always persist: are earnouts a good temporary remedy or rather a long-term quandary?
Noor Dewan is a Corporation Law LL.M. candidate at NYU School of Law and a Graduate Editor for the NYU Journal of Law & Business. Prior to attending law school, Noor worked for AZB & Partners on the Energy team in Delhi. She completed her undergraduate studies in Business Administration and Law at Jindal Global Law School, with a focus on sustainable finance.