Listen to this post

Private company buyers and sellers are more frequently using earnout provisions to help close the gap when they disagree over the price to be paid for the purchase/sale of the company. This creative solution can lead to conflicts, however, when the purchaser later contends that the earnout target was not met and, therefore, that no further amount is owed to the seller. In light of how commonplace litigation has become over the interpretation of earnout provisions in purchase agreements, this post offers practical guidance for buyers and sellers as they negotiate earnout terms that are designed to minimize post-sale disputes.

Earnout Provisions Can Help Achieve Purchase Transactions

Earnout provisions generally call for the buyer to pay most of the purchase price at closing, but also to agree to pay a potential additional amount on a contingent basis to the seller. The buyer is only required to pay this contingent amount to the seller if the business that is acquired achieves specific performance targets during a defined period after closing. For sellers, the earnout provides them with the opportunity to secure a much higher sale price following closing and usually after a transition period of one to two years. For buyers, earnouts lower the amount of cash they need to pay up front to the seller, and they also keep some risk in acquiring the new business on the seller, who may have to assist the business in performing well during the earnout period in order to secure the contingent payment.

Earnouts have become increasingly common, particularly in private non-life-science deals. According to the American Bar Association’s Private Target Mergers & Acquisitions Deal Points Study in 2023, the use of earnouts hit a new high that year. Many earnouts last for 24 months, although shorter or longer periods are not uncommon. Due to the increase in the use of earnout provisions in 2023, we have seen a large number of earnout disputes surfacing in recent years. Specifically, buyers and sellers are having conflicts over how to value the performance of the business after closing and how to calculate the compensation due under the terms of the earnout.

In Delaware, Vice Chancellor J. Travis Laster of the Court of Chancery put it well: “an earn-out often converts today’s disagreement over price into tomorrow’s litigation over the outcome” (see Airborne Health, Inc. v. Squid Soap, LP, 984 A.2d 126, 132 (Del. Ch. 2009)). For both buyers and sellers who desire to avoid future conflicts and litigation between them, careful drafting of earnout provisions is essential.

Start with Selecting the Least Controversial Metrics

The starting point for avoiding conflicts over earnout provisions is to choose the right metrics to determine whether any earnout compensation will become due. The two most common metrics are revenue based and earnings based, though other approaches — such as product launch milestones — are also possible. Using revenue as the target rather than earnings is generally more straightforward and less susceptible to manipulation by the buyer. The revenues the company generated are typically a clearer, more reliable benchmark, because earnings are determined after deducting expenses, and deductions from earnings can be a ripe source of conflict.

For example, earnings-based metrics, such as EBITDA, offer more room for dispute because they require agreement on how various expenses, adjustments, and accounting treatments will be handled in calculating whether an earnout has become due. If the parties are nevertheless insistent on using earnings as the benchmark, they need to consider how the seller’s business has measured earnings on a historical basis before the sale and how the acquiring company will calculate the earnings going forward. The parties should provide clear examples of how to calculate financial statements as exhibits to the purchase and sale agreement to ensure that they are on the same page regarding the manner in which the earnout calculation will be conducted.

Specific Guidance to Reduce the Risk of Post-Closing Conflicts

Based on our experience in handling earnout disputes, we prepared the following list of steps for company buyers and sellers to consider in negotiating an earnout provision that will help avoid or minimize future conflicts.

1. Clearly Define Accounting Practices

Whether negotiating a revenue-based earnout or an earnings-based earnout, the parties need to clearly define the accounting practices that will be used in valuing the business or any business-specific valuation issues. Vague language or assumptions and inside baseball descriptions that assume “everyone will understand what we mean” provide a recipe for future conflict and litigation. A mathematical benchmark that is based on a pre-sale valuation of the company may seem clear at the closing of the transaction, but disputes can arise down the road if the parties have not clearly defined how the target should be measured, including the following issues that can provide fertile areas for dispute:

  • Revenue Recognition Timing. The parties should specify when revenues will be recognized after closing — whether it will be done on a cash basis or an accrual basis. If management valued the business on a cash basis pre-sale, the use of accrual-basis accounting to measure earnout targets may be inappropriate and lead to disputes. The key is to make sure the parties accurately document their agreement so they are comparing apples to apples in calculating whether the earnout has been achieved.
  • Doubtful Accounts and Bad Debt. How to handle doubtful accounts and bad debt is an area that is specific to each business. Depending on the industry or business, accounts may be paid on slower timetables, and when the time arrives to compute the earnout payment, buyers and sellers may disagree on the collectability of aged accounts. The parties’ agreement must clearly define the parameters for including or excluding accounts the buyer deems doubtful in determining whether the required performance levels have been met.
  • Handling Adjustments. If the initial valuation was based on an adjusted EBITDA, the parties must set forth how these adjustments will be handled in calculating the earnout valuation. All accounting issues relating to the calculation of the earnout after the closing need to be addressed by the parties in their agreement to avoid later conflicts.
  • Expense Allocation. What expenses will be permitted and how will they be allocated to the acquired company after closing? This is particularly important if the acquired company is the target of a strategic purchase and will be folded into a larger enterprise. Corporate overhead allocations and shared services charges can significantly impact earnings calculations.

2. Retain a CPA to Assist in Drafting

Despite the significant negotiation of earnout provisions, these disputes frequently involve conflicts over how to interpret the specific requirements of the provision. One way to limit these conflicts or to prevail when they do arise is to retain a CPA who is directly involved in the actual drafting of the earnout provision.  A CPA can help identify business-specific accounting issues the deal lawyers may not anticipate, and they can ensure that the language used in the agreement closely aligns with accepted accounting principles.

3. Documentation

Another practical approach to help ensure the parties see eye to eye in calculating the performance of the business after closing is to attach financial or other revenue recognition statements to the purchase and sale agreement, which detail the model used to value the business and require that this same model be used by the parties when they calculate the earnout. Additionally, both parties should maintain documentation concerning the negotiation of the earnout provision and comments made related to the process. If a dispute arises, this contemporaneous documentation can be critical evidence of the parties’ intent.

4. Ensure Access to Records

Sellers may have less access to books and records once the deal closes. Even a seller who stays on board to manage the business after closing may have less access to financial records by the time the earnout is calculated months or years later. This lack of access can put sellers at a serious disadvantage. To address this concern, parties should consider including contract terms that facilitate the exchange of information necessary for sellers and buyers to align on the earnout valuation. These provisions should specify what records the buyer must maintain, how frequently the seller can request access to the records, and in what specific format the information will be maintained and provided.

5. Appoint a Referee

To avoid litigation, the parties can stipulate that all accounting disputes relating to the calculation of the earnout will be decided by a CPA firm the parties designate to serve as the neutral referee. For this provision to work well, the parties need to list the CPA firm (or firms) to be used in their agreement and also specify how the referee will resolve these disputes by detailing (i) the information to be provided to the referee, (ii) the process the referee is to follow to resolve the disputes, (iii) the timetable for the referee to decide the matter, and (iv) by mandating that the referee has sole authority to resolve disputes relating to the earnout.

6. Arbitration If Required 

Despite the appointment of a referee, the parties may engage in conflicts over the actions or rulings of the referee, and in that event, these disputes should be resolved exclusively by the filing of a fast-track arbitration that will take place in a matter of 60-90 days. This requirement of mandatory arbitration is the last fallback in the dispute resolution process to ensure that all conflicts between the parties relating to the earnout will never become bogged down in litigation.

Conclusion

The goal shared by company buyers and sellers of structuring a win-win deal is what leads them to adopt an earnout provision because the contingent purchase price works for both sides.  But for a contingent provision to successfully stand the test of time, it cannot result in the parties becoming locked in combat. A well-drafted earnout provision enables the parties to head off potential disputes at the drafting stage before they ever become embroiled in litigation.

Crafting an earnout provision that will avoid future conflicts is possible when the parties are assisted by CPAs during the drafting stage, when they draft contract terms based on the actual performance of the company being acquired, when they attach financial statements that govern the calculation of the earnout, and when they provide for access to all documents necessary to conduct the calculation of the earnout. Finally, if conflicts do arise, the earnout provision needs to provide for the appointment of a referee to resolve these disputes, and ultimately, for an arbitration to take place that will result in a final, non-appealable award if the parties stymie the referee’s efforts. 

Listen to this post

Minority investors often purchase interests in private companies without securing a buy-sell agreement (BSA) at the time of their investment. After a few years pass, however, the minority investor and the majority owner may both want one, but for different reasons. The majority owner may desire to redeem minority interests in the company held by smaller investors, which will then enable the owner to offer a larger stake in the business to just one, well-funded investor.  The investor may want to secure an off ramp to be able to monetize the investor’s minority interest in the company at some point in the future.

When the business goals of majority owners and minority investors align, these partners can create a BSA in the nature of a post-nuptial agreement, which they enter into long after the purchase of the minority interest. This post reviews how to structure these after-the-fact BSAs between existing business partners.

Why Partners Consider a BSA Long After the Investment

When majority owners and minority investors first begin to see the need for a BSA years down the road, it is because they did not consider their long-term business goals at the time of the initial investment. The majority owner may have focused on the company’s immediate capital needs while the minority investor’s primary focus was on evaluating the quality of the business and whether to go forward with the investment. 

With the passage of time, however, the majority owner may conclude there are too many small investors in the company and the owner may therefore want to secure the right to redeem some of them to regain control over the company cap table. At the same time, the minority investor may realize that without a BSA in place, the investor will have to wait for some type of liquidity event to take place to be able to monetize the interest held in the company.  In short, the minority investor may want to secure a contract right to demand a repurchase of the investor’s interest in the business.

Under these circumstances, the parties’ separate but aligned interests may open the door for them to discuss negotiating and adopting a BSA. This post-nup BSA will allow each of them to achieve their business goals well after the investment was made. Reaching this type of agreement will be possible, however, only when the relationship between the partners is not already in crisis.

Key Features of the After-the-Fact BSA

There are four key components of the type of BSA that business partners enter into after-the-fact. These are (1) the timing, i.e., when either party is permitted to trigger the buyout right provided by the BSA, (2) the method for valuing the minority interest, (3) a look- back provision that protects the minority investor whose interest is being redeemed, and (4) the structure of the payment to be made for the purchase of the minority interest. 

The last two of these provisions are common in all BSAs, and we have covered them in a previous post that can be accessed here. We will therefore address just the first two, the timing of the parties’ right to trigger the BSA and the importance of the look-back provision. The partners who enter into the BSA after the initial investment will not want to permit the BSA to be triggered right away. If an immediate buyout was desired, the partners would simply negotiate the purchase of the minority interest, and they would have no need to create a BSA to be triggered in the future.

Thus, this type of BSA will include a delayed trigger, which means that neither of the partners will be permitted to trigger the BSA for a period of years, and the specific length before the trigger is permitted is subject to negotiation. It generally falls in the range of two to four years, and after this time period passes, each partner will have the option to trigger the BSA and require a redemption or buyout of the minority interest.    

The look-back provision specifies that if the majority owner triggers the BSA and then redeems the interest held by the minority investor, the investor will have a protected period of time (often for at least one year) after the redemption. During the protected period, if any transaction takes place at a higher share value than the minority investor received, e.g., if there is a sale of the company or a new investment in the business, the investor will receive an equalizing payment based on the value of the transaction during the protected period. In short, the investor does not have to worry that shortly after its interest was redeemed, the majority owner sold the business for a much higher value. 

Conclusion

The failure to obtain a BSA when an investment is made does not foreclose either the company’s majority owner or the minority investor from raising this new agreement as a possibility years later. But if the relations between the partners have deteriorated over time, the prospect of securing a post-nup BSA becomes remote at best. Therefore, business partners who are interested in potentially entering into an after-the-fact BSA need to act before the window closes as it likely will not stay open forever.

Listen to this post

The use of AI has been a boon for business owners, because it enables them to analyze large amounts of data quickly and inexpensively, which accelerates their decision-making process without the need to consult others. This expansive, fast input can make it appealing for business owners to consider replacing their human business partners with an AI subscription, i.e., securing the same wisdom but without any hassles. The temptation to jettison human partners for an AI substitute, however, poses serious risks, including (1) the loss of access to capital, (2) the lack of real-world experience that challenges the owner’s views, and (3) increasing the isolation that many business owners already feel in leading their companies. This post reviews benefits for business owners who incorporate AI into their operations but also considers negative outcomes that may result if owners abandon their human partners and place sole reliance on digital guidance.

The Benefits of Implementing AI for Business Owners

The targeted use of AI provides business owners with significant value.  AI tools can quickly analyze data regarding sales, pricing, manufacturing, labor and other costs, and they can also provide owners with detailed financial projections and guidance on a 24/7 basis regarding strategic options that are available to expand their business. The incredible speed at which AI processes information permits business owners to make decisions on an expedited basis. The takeaway is that business owners can deploy AI tools to improve their bottom line by achieving cost cutting or increasing profits, or some combination of the two.

But if business owners opt for the use of AI in a way that eliminates or sharply reduces the role of their human partners, this decision can lead to dire consequences for the business, which are discussed below.

Loss of Access to Capital

As businesses grow, they often need to secure additional capital to fund the costs of their expansion and avoid becoming burdened by excessive debt. That is one of the reasons why a private company owner may add business partners who can contribute capital, as well as opening doors to other new sources of capital for the business. 

While AI is a helpful digital resource that can identify potential new sources of capital for the owner to consider, AI cannot directly open doors for business owners to secure capital from human partners. Stated another way, AI cannot write checks, and securing an AI subscription will not create introductions to a new network of friends and colleagues who have capital to invest in the business. As a result, an AI strategy that deemphasizes human partners may close off or reduce access to new capital sources the business needs to expand.

Lack of Real-World Experience

AI has vast amounts of knowledge and analytical capacity, but it does not provide input based on actual life experience. Experience in life is often the best teacher, but AI has not gone through a market downturn, laid off employees or scaled back a business in response to adverse market conditions. We learn more from our mistakes than our successes, and partners who have experienced setbacks have invaluable life experience they can tap into, which they can rely on to help business owners avoid repeating the same costly mistakes the partner made in the past.

A couple of examples may help make this clear. AI can evaluate a resume and point out the pros and cons of a potential lateral hire for a management position. But a business partner who has experience in the industry will have a strong sense of what personality and skill set is necessary for success, and in addition, the partner may have industry contacts who know the candidate and may be able to offer inside information about the specific applicant. This type of real-world experience may help avoid hiring someone who would be a disaster for the business.

Similarly, AI can analyze various performance indicators, compare compensation structures, and offer guidance to the business owner about how to create a strong company culture. But an experienced business partner can assess what is not working in the company’s culture and offer suggestions that will help build a more vibrant and cohesive work environment. From popular culture, the recent Top Gun remake featured Tom Cruise taking his pilots to the beach for a touch football game. The flight commander wanted the pilots back in the classroom, but Cruise’s character knew that team bonding on the beach would bring them closer when it counted. Here, AI may offer ideas that make sense on paper without appreciating what truly fosters human connection. 

The Echo Chamber Effect — AI as Cheerleader

Depending on the AI model, the results may be supportive without offering hard-hitting and necessary critique. AI is a composite of huge amounts of data that can be analyzed at breakneck speed. But it does not have skin in the game as it has not invested time or money in the business, and it could be weighted toward confirmation bias. When a critical decision requires the application of informed judgment rather than mathematical certainty, does the business owner want to trust the information that AI provides to one of its subscribers? Or would the owner place more trust in advice offered by someone who shares the same risk of success or loss in the business?

In short, human business partners are likely to be more accountable than AI on key decisions such as the hiring or firing of employees, investing in new areas of the business, or deciding on which potential new business partners to bring into the business. Will AI provide the business owner with a firm “no” when a key decision has to be made, and if so, will the answer be trustworthy? Ultimately, the business owner must decide whether to accept advice that is being offered solely by AI or whether to insist on also obtaining thoughtful input from another experienced businessperson. 

Isolation and Its Consequences

A final issue for the business owner to consider is whether using AI to the exclusion of human partners will become more isolating. Running a business can be lonely when the buck stops with the owner who has to make final decisions frequently. A business owner who consults solely with AI in making decisions to the exclusion of human partners may become more disconnected and disengaged, which is not healthy. A study conducted by the University of California, San Francisco, found that 49% of entrepreneurs deal with at least one mental health condition. Common issues include anxiety, depression, and burnout.

AI can help the business owner make decisions far more promptly. But creating a business model that involves seeking collaboration and consensus with others who are part of a management group can create a much stronger sense of teamwork for the owner and the company as a whole. Engaging in this collective teamwork also will help the business owner avoid experiencing burnout and depression.

Conclusion

AI is here to stay. The benefits it provides for business owners are profound, and its ease and accelerated delivery of results add to its utility. But jumping on the AI bandwagon should not lead business owners to dispense with their human business partners, whose real-life experience, extensive contacts, and wisdom add value to the company in a host of different ways. The balance that can be struck here, instead, is for business owners to use AI tools to enhance the work they do with their business partners, whose wise input can make the use of AI even more positive and impactful for the business.