The rationale underpinning earn-outs is that they align the interests of the buyer and the seller-entrepreneur; the better the target business performs post-deal, the greater the return on the buyer’s equity and the earn-out payment for the seller.
However, Glafkos Tombolis, corporate partner of law firm Kemp, suggests that the reality of earn-outs often doesn’t match the theory.
This is usually because the earn-out provisions contained in the definitive transaction documents are overly complex and very difficult to administer in practice. It’s also often because the earn-out mechanics fail to anticipate a scenario relating to the target business that eventually comes to pass, for example a decision taken by the buyer to on-sell it.
This can result in the buyer and seller simply ignoring the detailed earn-out mechanics, sometimes culminating in the seller being “bought out” of his right to receive the earn-out.
Unfortunately, it can also result in the buyer and seller disputing the scope and meaning of the earn-out wording contained in the deal documents.
Compounding the problem is that there is scant judicial precedent in the UK relating to earn outs. However, the recent case of Porton Capital Technology Funds v 3M UK Holdings Ltd represents a very useful indication of what can go wrong.
In that case, the earn-out provision under dispute imposed an obligation on the buyer to “diligently” seek regulatory approval and “actively” market the target’s products. However, as it turned out, the buyer decided to terminate the target business after it acquired it, as it was unprofitable. As a consequence of the termination, no earn out payments were made to the sellers, hence the claim brought by them for breach of the obligations just referred to.
The court agreed that the buyer did not “diligently” seek regulatory approval, as it failed the objective test of reasonable application, industry and perseverance. The court also took the view that the buyer did not “actively” market the products, since this required its efforts to be backed by action, i.e. an element of proactivity was needed, which was missing.
The final point considered was whether the sellers had acted unreasonably in withholding their consent to the termination by the buyer of the target business. The court, applying established case law, concluded that the sellers had acted reasonably; the sellers were entitled to have regard to their own interests in maximising the earn-out payment and did not need to balance their own interests with those of the buyer.
What can we take away from this?
From a seller-entrepreneur’s perspective, a lot of time, and expense, can be incurred in negotiating the minutiae of earn-out provisions, only to find that a determined – and well-resourced – corporate buyer will either seek to enforce aggressively the earn-out provisions to the letter (if they are in its favour) or goad the entrepreneur into litigating against the buyer (if they are not).
In either case, the inevitable result will be that the entrepreneur becomes distracted from doing what he or she was meant to: run and develop the target business for the benefit of all stakeholders.
This leads to the conclusion that sellers should seek to short-cut the potential for costly negotiations over earn-out provisions and future disputes relating to them before detailed discussions about earn-outs even begin by seeking a middle ground with the buyer, i.e. by agreeing to receive more up front for the sale of his or her business in return for a lower potential payment in the future.
At the very least, entrepreneurs should not reflexively agree to an earn-out simply because they are a common feature of corporate transactions. Don’t always follow the crowd.
