Thinking About Your Earn-out
Difficulties surrounding earn-outs in mergers are nothing new, but a new study recently released by the Mergers and Acquisition Law Report by BNA points to an increase in the use of earn-outs due to greater economic uncertainty. Earn-outs in general involve a practice of tying some portion of the purchase price for a company to the performance of that company after the merger closes. Earn-outs can be tied to a variety of milestones, including financial and non-financial objectives.
The BNA study counsels companies to consider carefully the provisions of earn-out provisions in merger agreements as courts are reluctant to intercede on the seller’s behalf. In particular, BNA suggests that the remedy for the buyer breaching an earn-out provision should include liquidated damages. This can be easier said than done, determining the amount the selling company would have received had it not been for the buyer’s breach can be difficult to determine. Buyers will sometimes make arguments along the lines of “well maybe we breached some obligation, but they wouldn’t have met the milestone regardless.” It can be hard to prove that is not the case, and damage calculations can therefore be difficult to prove. Unfortunately, the duty to do so can land on the seller.
The over-arching lesson from the study is to avoid any ambiguity and BNA makes three concrete suggestions for drafting earn-outs:
On the first point, we agree. We also suggest that the milestone be easily ascertainable with a binary outcome when possible. For instance, it’s easier to determine whether a drug got FDA approval than it is to determine whether a division of the company had $10M in revenue. The latter is subject to all sorts of possible games or manipulation.
The second point sounds great, but this is a really hard one to get buyers to agree to. Buyers want to control the company they’re buying and, in our experience, won’t give on this very often.
The third point makes sense but has the damages calculation issue outlined above.
Overall, though, it’s an interesting report.
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