Earn-out provisions in purchase contracts are “sweeteners” than can add significant value to the purchase price in the sale of private companies and these terms are increasingly being used in purchase contracts. This Post explains why the use of earn-out provisions is on the rise in purchase contracts, but it also signals a warning. As a Texas Supreme Court decision last year made clear, if earn-out provisions included in purchase contracts do not address all key issues and are not drafted with care, their use may result in serious legal problems.
The “Why” of Earn-out Provisions
In the sale of a business, the purchase price and the timing of the transaction are two of the most important terms in the purchase contract. If the parties cannot agree on these key points, a deal is not likely to happen. Using an earn-out provision, therefore, is one way of bridging the gap when the parties differ on these terms. Including an earn-out provision in the purchase contract provides the seller with the future opportunity to receive a higher purchase price if the business performs well after closing. But, the buyer is not required to pay this higher price at closing. The earn-out provision therefore provides the buyer with the means to provide a deferred, contingent payment to the seller.
The earn-out provision can also help with the timing of the sale. When the seller believes the company is poised for future success, he/she may be reluctant to conclude a sale that effectively “leave money on the table.” In this situation, the buyer can agree to include an earn-out provision in the purchase agreement, which will provide the seller with the ability to continue to share in the company’s future profits for some defined period of time.
Key Issues to Address in Earn-Out Provisions
Specify the Formula for Determining the Earn-Out Payments
While earn-out provisions can be remarkably helpful in structuring the sale/purchase of a business, they can also be the source of major legal disputes. Just last year, the Supreme Court decided whether an earn-out clause was a valid, binding contract provision or an unenforceable agreement to agree. See Fischer and Corporate Tax Management v. CTMI, L.L.C. and Raymond, No. 13-0977 (Tex. Sup. Ct. October 12, 2015).
In Fischer, the earn-out provision at issue included a formula for future earn-out payments to be made to the seller, but required the parties to mutually agree on the percentage of work that the seller completed in future years. When the parties could not agree on this percentage, the buyer argued that the earn-out provision was unenforceable as an agreement to agree in the future – not a binding commitment. The Court determined, however, that the clause was sufficiently definite to enable a court to determine the buyer’s obligations and to provide a remedy for its breach. The Court stated, “when the parties ‘have done everything necessary to make a binding agreement . . . their failure to specify the price does not leave the contract so incomplete that it cannot be enforced.’”
While the seller in Fischer was ultimately successful in upholding the earn-out provision, this success was achieved only after a trial, a loss before the appellate court and ultimate success before the Supreme Court. This is not the path that any seller wants to travel, which is why all of the terms in the earn-out provision should be detailed in spelling out the specific obligations of each party during the earn-out period.
Detail the Seller’s Continuing Duties
A second danger in using earn-out provisions, and one which leads frequently to disputes with the client, are the seller’s duties after closing. The seller is often someone with a history as the former owner of the business and if his/her role in the company after the sale is not carefully detailed, the parties’ expectations regarding the duties and performance of the seller during the earn-out period are in direct conflict. The earn-out provision should therefore specify all of the following: (i) the scope of authority the seller will continue to retain in regard to company employees, (ii) the exact duties the seller is to perform and any written reports the seller is required to provide, (iii) number of hours that the seller is expected to work on a weekly basis, (iv) the identity of the person to whom the seller reports, and (v) the extent to which the seller has the right to direct the company, and determine its processes, strategies and business plans.
The bottom line is that the buyer and seller need to have a candid, detailed discussion about their expectations for the seller’s role before the purchase takes place. Failing to make sure that all parties have the same understanding in this important regard is leaving the door open to future disagreements and the prospect for litigation.
Maintain Transparency and Confirm Audit Rights for Seller
The essence of an earn-out provision is that it provides the seller with a continuing financial interest in the future success of the business after the purchase. As a result, the seller needs to insist that the company provide him/her with financial reports on a regular basis that reflect its financial performance, and in addition, to request the company to secure an audit of the company’s books at least once a year if not more often.
The need for transparency in the operation of the business and the need for the seller to have audit rights are critical parts of the earn-out provision granted to the seller. These rights ensure that the seller will have the means necessary to confirm that all payments the buyer is required to make under the terms of the earn-out provision are fully paid to the seller.
Dispute Resolution Procedure
Given that earn-out provisions in purchase contracts have become such a frequent source of post-closing disputes, the parties should consider including a dispute resolution procedure in their purchase agreement. Lawsuits can drag on for several years, and a victory that is earned only after years of litigation and appeals will not feel like a cause for celebration.
In previous Posts, we discussed the benefits of resolving certain disputes with a “fast track” arbitration procedure rather than litigating these claims in state court. In disputes involving earn-out provisions, the fast track approach to arbitration should enable the parties to resolve their disputes quickly, cost-effectively and privately, which makes it a potentially attractive option in this context.
When used with precision, an earn-out provision provides private company buyers and sellers with an effective tool to accomplish their business objectives. These business goals may include providing the seller with the opportunity to receive additional funds over time based on the company’s future performance – this offers a significant contingent upside.
The intended sweetener provided by the earn-out provisions may quickly sour, however, if the parties do not focus on their business goals in negotiating this term and if they fail to act with care in selecting the actual language used in the contract. Inserting an earn-out provision in a purchase agreement without due care may result in disputes between the parties in the future regarding issues such as the seller’s performance, calculation of the amount due to the seller under the provision and the results of financial audits conducted by the seller.