Earn out Provision disputes in Share Purchase Agreements

Earn out Provision disputes in Share Purchase Agreements

Earn-outs in Share Purchase Agreements (SPAs) are payment structures tied to the future performance of the target company. They allow buyers and sellers to share future business risks and benefits, aligning both parties’ interests by rewarding the seller if the business performs well post-sale. Here’s a closer look at earn-outs and ways to manage common disputes arising from them.

Earn-out Provisions

Earn-outs are commonly used when the sellers remain involved in the business, often as directors or key employees, after the sale. They are especially useful when the buyer and seller have differing views on the target company’s value or growth potential. Normally, the buyer makes an initial payment upfront, and additional payments are made based on the company meeting specific performance milestones, such as revenue or earnings before interest, taxes, depreciation and amortization targets.

The inclusion of an earn-out benefits both parties:

• For Sellers: It offers a return if the business meets or exceeds targets.
• For Buyers: It ensures sellers remain invested in the business’s success post-acquisition.

What are the Common Causes of Earn-out Disputes?

1. Wording: Vague language can create confusion over earn-out conditions. Disputes may arise around terms like “revenue” or “profit,” differing interpretations of financial metrics, and accounting methods.
2. Problems Post-Completion: Sellers may claim buyers have taken actions that reduce the likelihood of meeting earn-out targets, whether by changing business strategies or withholding necessary resources. Buyers, on the other hand, might argue that their decisions are in the company’s best interests, even if they impact the earn-out negatively.
3. Problems relating to Financial Reporting: Earn-out payments often depend on financial reports. Disputes arise over issues like revenue recognition, cost allocations, or accounting adjustments, as either party may feel these financial presentations distort the company’s true performance.
4. Earn-out Payments Timing: The timing of calculations and payments can also lead to disputes. Disagreements may stem from when the earn-out period starts, its duration, and the due dates for payments.

Steps that Parties can take to prevent earn-out disputes arising:

1. Drafting: Ensure the SPA clearly defines financial metrics, calculation methods, accounting standards, and timelines. Provide illustrative examples of how the earn-out will be calculated to eliminate potential ambiguity.

1. Third-Party Review and Auditing: Including a third-party auditor for financial statements used in earn-out calculations can provide unbiased validation, ensuring both parties trust the accuracy of financial data.
2. Guidelines for Post-Completion: Set guidelines for post-acquisition management, especially if the seller remains involved. Establishing clear decision-making authority can prevent disputes around actions that might impact earn-out metrics.
3. Creating Governance Mechanisms: Creating an earn-out committee or similar governance mechanism can improve communication and transparency, offering oversight on earn-out target achievements.
4. Dispute Resolution Processes: Embed mediation, arbitration, or expert involvement as dispute resolution options in the SPA. These mechanisms offer more efficient and cost-effective solutions than litigation.

By addressing these points during the drafting phase, both buyers and sellers can reduce the potential for disputes, ensuring the earn-out mechanism functions as intended and both parties are aligned towards the company’s post-sale success and avoid any disputes arising.

If you are involved in a share purchase involving an earn-out and want legal support please contact Head of Commercial at Attwells Nick Attwell on 01473 229242 or email Nick at [email protected]

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