By Bharat Moudgil
On April 23, 2013, Marc Mantell, a partner in the business law group of Edwards Wildman Palmer LLP, discussed the nature and effect of earnouts in the American business landscape. His presentation, entitled Earnouts: Managing Risks and Navigating Traps for the Unwary was an introduction to not only the concept of earnouts, but the litigation that is helping define their boundaries and application.
To begin with, what is an earnout? An earnout is a purchase price for a business that depends on that business achieving preset performance targets after closing. Essentially, the seller can obtain future compensation based on the business achieving certain goals. Earnouts come into play when there is a disagreement over the value of the business – the uncertain buyer only has to pay more over time if the business “…proves that it is worth more.” (Airborne Health, Inc. v. Squid Soap, LP ). Therefore, earnouts bridge a valuation gap, while simultaneously allowing buyers to offload risk.
The market saw an uptick in earnouts during the Great Recession, and in 2010, 38% of deals included them. That number shrank by 2012, but over 80% of transactions involving biopharmaceutical and medical device companies involved earnout provisions.
Earnouts are calculated based on several metrics, most commonly financial statistics such as revenue, net income, EBITDA, and gross margins. Additionally, an earnout can be based on the number of units sold, or non-financial milestones such as the timeline of a product lunch or regulatory approval. Unsurprisingly, revenue-based earnouts are more administratively convenient than those based on metrics which are not easily quantifiable.
An earnout period typically lasts 1 to 3 years, but can stretch up to 10 years or longer. The structure of the targets and corresponding payouts varies from flat amounts to pro-rated payments based on missed goals or thresholds, and from cash consideration to securities or some combination.
Lawyers negotiating earnouts have a myriad of issues to consider, as they will impact the resolution and application of these terms to contracts. For example, negotiators will need to decide what counts towards the earnout, as well as what counts against.
A question which has recently arisen and promises to impact the future of earnouts is how the business should be required to operate after the transaction closes. Namely, does the buyer have a duty to operate the business in order to maximize earnout payments? Over half of deals in 2012 which involved earnouts contained operational covenants that impose limitations on the buyer’s authority to manage the acquired business. Other terms include requiring “commercially reasonable efforts” to maximize earnout payments, while others utilize negative covenants which prevent the buyer from operating the business in such a way that would reduce the amount of a potential earnout payment.
Over the last decade, courts have begun to reason certain implied obligations in respect of earnouts, applying Delaware law (in O’Tool v. Genmar Holdings, Inc. and Airborne Health, Inc. v. Squid Soap, LP) as well as Massachuetts law (in Sonoran Scanners, Inc. v. PerkinElmer, Inc. ). In these cases, where there was no express provision requiring the buyer to spend resources in furtherance of the earnout, courts have held that the buyer is held to an implied standard of good faith and fair dealing, or in the case of Sonoran Scanners, requiring it to use reasonable efforts. Therefore, the terms of the contract will impact the outcome of a potential dispute – lawyers will need to analyze the structure of the earnout as well as the business itself to tailor solutions for their clients.
Litigation is not the only answer to earnout provision disputes. Lawyers can suggest arbitration clauses, as they are less expensive than going to court, and typically more efficient. Arbitration provisions also often contain a fee-shifting provision which for the prevailing party, which can drastically affect the economics of the dispute and weed out frivolous claims. However, discovery in arbitration proceedings is limited and tends to favor the buyer, the party with more information.
Mr. Mantell’s discussion was helpful in engaging not only members of the audience with experience in negotiating and drafting earnouts, but novices in the field. The growing frequency with which transactional attorneys will encounter earnouts, especially as corporate clients move into the pharmaceutical and biotech spaces, warrants more discussion of this topic. Bharat Moudgil is a Corporate Associate at Proskauer Rose LLP, and a member of the Multi-Tranche Finance Group, resident in the Boston office.