Earn-outs, a contingent purchase price adjustment mechanism, are a common feature of private M&A transactions, especially where there is some uncertainty around valuation and future performance. For example, a motivated buyer enticed by future growth projections may be prepared to pay a higher multiple of earnings for a business than other prospective purchasers but, in exchange for doing so, may require that a portion of the purchase price be contingent on the business achieving those growth projections. If the seller believes the proposed growth targets are attainable and wishes to extract the higher pricing, it may be agreeable to an earn-out.
Virtually all earn-out provisions include the following components:
- A portion of the purchase price being contingent.
- Metrics for calculating the earn-out (often EBITDA or some other objective financial measure).
- Earn-out targets (typically based on reference to a baseline or achieving a milestone).
- Method for calculating the earn-out (GAAP or customized/normalized calculations with certain inclusions and exclusions).
- Timing of earn-out and payment (at least one year and often a multi-year period with payment following preparation of audited financials).
- Post-closing restrictions on the operation of the business.
Given the possibility of being presented with an earn-out, sellers should be careful not to be overly optimistic when marketing the future growth prospects of their business. It could come back to haunt them in the form of a purchaser presenting them with unachievable earn-out targets. Trying to back away from prior rosy financial projections will inevitably lead to a loss of credibility and trust.
As earn-outs are conditional and dependent on a number of variables, some of which are outside the control of the parties, drafting and negotiating earn-outs is a complex exercise which must be undertaken with great care. An area of frequent disagreement are the post-closing operating covenants of the target’s business. While buyers typically prefer to say little on the issue leaving them in full control post-closing, sellers prefer post-closing covenants which require the buyer to conduct the acquired business so as to ensure or maximize the earn-out payments.
Agreeing that the target business will operate as it has in the past during the earn-out period is obviously the easiest solution to ensuring an “apples-to-apples” comparison for the purposes of the earn-out calculation. But what about a strategic purchaser who wishes to integrate operations soon after closing? Is it possible to do so and still have an earn-out that is calculated on a reasonably equivalent basis pre- and post-closing so as to avoid disputes?
The relatively recent decision of the Ontario Court of Appeal in Whiteside v. Celestica International Inc. highlights how difficult that is and how lawyers and their clients must turn their minds to carefully drafting earn-out provisions when integration is contemplated during the earn-out period.
In Whiteside, the purchaser directed certain work that it independently generated to the acquired business entity during the earn-out period, including part of a large and profitable contract it won with NEC. The acquired business had the capacity and expertise to do the NEC work and the purchaser believed the NEC earnings were excluded from the earn-out calculation based on adjustment provisions in the purchase agreement. Unfortunately for the purchaser, the Ontario Court of Appeal did not agree with that interpretation and, among other things, pointed to the conduct of the purchaser including several other smaller projects, very similar to the NEC project, in the earn-out calculation as supporting its interpretation. The result being that the court ordered the NEC earnings be included in the earn-out calculation likely triggering the earn-out payment. The actual determination of whether or not the earn-out threshold was met with the NEC earnings was sent back to trial by the Court of Appeal.
Some takeaways from Whiteside:
- Operating an acquired business as a standalone during the earn-out period is likely the easiest means of avoiding post-closing disputes about operations and earn-out calculations.
- If some partial integration is planned during the earn-out period, lawyers and their clients should carefully consider the impact of the integration. It may be necessary to expressly included and excluded certain items from the earn-out and provide for certain adjustments.
- The method of calculating the earn-out post-closing should be performed on a consistent basis for all matters regardless of impact on the earn-out. Conduct matters in contract interpretation.
- With the Supreme Court of Canada’s recent decision imposing a duty of good faith on contracting parties, buyers and sellers should not leave the issue of post-closing operational covenants silent.