Structuring the payment of a target company in a Share-Purchase Agreement (“SPA”) is an important factor for both the seller of the target and the buyer throughout negotiations. While one option is to agree on a fixed price, in times of economic uncertainty, such as the current interest rate environment, accurately predicting the target’s future performance can be challenging. In these uncertain times, agreeing on adjustable considerations using earn-out provisions (“EOPs”) has become highly popular.

But what should the parties be mindful of to ensure that their EOPs are bulletproof against disputes.

What are Earn-Out Provisions?

Simply stated, EOPs are price mechanisms that bridge the gap between the seller’s and the buyer’s expectations.

An earn-out describes an arrangement in which at least part of the consideration for the sale of a target in a SPA is determined by the future profitability of the target over a specified period post-completion. Typically, an earn-out period is between 1 to 3 years.

Earn-out provisions are particularly appropriate when the seller of the target continues to manage the target after completion. By shifting some of the risk of weak post-completion performance from the buyer to the seller, these provisions allow part of the purchase price to be paid at completion, followed by one or more additional payments based on the profits made by the target within the agreed timeframe.

Earn-out provisions not only protect buyers by preventing overpayment for a target that may not perform as expected, but they also serve as a motivating factor for sellers who continue managing the target post-completion.

Although EOPs come in handy during uncertain times, they may become a subject of  dispute.

Factors Causing EOP Disputes

Utmost attention must be given when drafting EOPs, as sellers who continue to manage the target and buyers who purchase the target may be pulling in different directions which consequently lead to EOP disputes. While sellers are typically focused on maximising the target’s profitability, buyers may prioritise decisions that benefit the target’s long-term growth rather than its profitability within the specified period after completion.

Aside from differences in operational control post-completion, EOP disputes often arise, from several common factors, which can be identified as follows:

• ‍Poor Drafting

SPAs are contracts that govern the sale of a business. As with any vaguely drafted contracts, if EOPs are unclear or terms are poorly defined, disagreements over the EOPs are highly likely.

For instance, the provisions may lack clarity on how to calculate the performance measures which are central to earn-outs.

Additionally, pivotal terms such as “good leaver” or “bad leaver” may not adequately address scenarios where a seller leaves their employment with the target, or outline how this would impact the earn-out.

• ‍Preparation of Accounts

Disputes between a buyer and a seller about the method used in preparation of accounts are another common factor. While it is typically expected that accounts will be prepared consistently with the target’s pre-completion methodologies,  the buyer’s new policies may render it challenging to maintain the same financial reporting methodologies difficult post-completion.

Sellers may argue that the buyer’s improper accounting principles led to a decrease in the target’s profitability. Conversely, buyers could argue that the sellers had presented an over-optimistic view of the target’s prospects.

• ‍Timing of Earn-Out Payments

‍Disputes may also arise regarding the start of the earn-out period, its duration or the payment due dates.

How to prevent potential EOP disputes from arising?

To start, parties must set realistic targets.

As with any legal document, utmost attention should be given to drafting that should be clear, precise and, comprehensive. All key terms, including financial metrics, calculation methods, accounting standards, and timelines should be clearly defined. Parties should also aim to avoid overly complex calculations or measurements.

To minimise potential disputes over the control of the target, the SPA could define the target’s objectives during the earn-out period. Alternatively, the SPA may impose certain limitations on the conduct of the target post-completion by providing guidelines for decision-making.  

Specifically regarding the preparation of accounts, the SPA could require an independent third-party auditor to review the company’s financial statements used for calculating the earn-out. This independent audit would offier greater confidence in the accuracy of the calculations. Moreover, including specific governance mechanisms, such as an earn-out committee responsible for the achievement of targets, can enhance transparency in the target, and reduce the risks of disputes.  

Finally, like any well-drafted contract, incorporating alternative dispute resolution mechanisms is paramount. These mechanisms can provide a more efficient and cost-effective approach to resolving disputes relating to EOPs.

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