Earnouts Often Result in Disputes
How to avoid and/or mitigate the risk of earnout disagreements.July 7, 2011
by Allen Liebnick, CPA, CFF
In last month’s column, Attorney-at-Law and Partner with the Texas-based law firm Looper Reed & McGraw, Mark Wigder, explained the applicability of earnouts in a sales and/or purchase arrangement. Wigder is well versed in earnouts since his firm focuses on corporate and securities law, mergers and acquisitions, public offerings, private placements, financings, SEC compliance and corporate governance as well as what earnouts are and, among other things, various points to consider in negotiating the earnout. Earnouts often result in litigation. As Vice Chancellor Travis Laster of the Delaware Chancery Court observed in the Airborne Health case: “[A]n earn-out often converts today’s disagreement over price into tomorrow’s litigation over outcome.” This article will address the common areas of disputes with respect to earnouts and how to avoid and/or mitigate the risk of earnout disagreements.
The Most Common Types of Earnout Disputes
How to Avoid and Mitigate Earnout Disputes
Wigder pointed out that failure to draft earnout provisions and address all potential facts and scenarios that may arise carefully can often lead to litigation. He also said that “courts have been reluctant to intercede on the seller’s behalf in the absence of specific protections in the acquisition agreement or employment agreement. Thus, it is critical that sellers are proactive about protecting their rights during negotiations of the earnout rather than waiting for litigation.”
Clear and Exhaustive Contract Terms. Most earnout disputes boil down to different interpretations of the earnout agreement. By planning ahead and making decisions upfront, parties to earnout agreements may be able to avoid future litigation over potential ambiguities. Important terms to consider are:
Selecting a Favorable Law to Govern the Agreement. Parties should aim to select a governing law in the agreement that is most likely to produce a favorable outcome should the earnout agreement come to litigation, as well as the jurisdiction to hear such litigation. A favorable governing law, as well as a favorable venue, is of particular importance in
Including a Liquidated Damages Clause or Other Remedies. In certain circumstances, courts have found earnout damages are too speculative even if a court finds that a buyer has breached the earnout agreement resulting in an award of nominal damages. Therefore, the parties should consider including a liquidated damages clause. From the seller’s perspective, the seller should argue for a provision that accelerates the earnout payments (i.e. similar to a promissory note) to the seller if the buyer breaches the earnout agreement or employment agreement of the seller’s management, including terminating members of such management without cause.
Including Dispute Resolution Mechanisms in the Acquisition Agreement. The acquisition agreement should include provisions on how to settle earnout disputes in the event that they arise. Most acquisition agreements include an arbitration clause.
ConclusionBy being cautious and taking these precautionary steps, both buyers and sellers can avoid unnecessary headaches over possible litigations.
Allen M. Liebnick, CPA, CFF, is president of Overpaid Payables Recovery, Inc.. He has been providing accounts payable, sales tax and telecommunications post-audit recovery services for over 18 years. Liebnick is a member of the New York State Society of CPAs as well as Texas Society of Certified Public Accountants and chair of the 2011 Texas State Society of CPAs State Tax Conference. Liebnick thanks Mark Wigder for his contribution to this article.