Earnouts have become an increasingly common feature of mergers and acquisitions transactions in recent years, particularly in private equity deals where platform companies are acquiring smaller businesses as add-ons. Earnouts serve as a mechanism to bridge valuation gaps between buyers and sellers by tying a portion of the purchase price to the future performance of the acquired business.
However, earnouts often lead to disputes, especially when expectations are misaligned or performance metrics are ambiguous. For private equity-backed platform companies, effectively navigating these disputes is critical to preserving value and maintaining relationships.
Adding to this complexity, earnout disputes are particularly challenging when the seller and recipient of the earnout is also part of the management team and party to an employment agreement. This dual role introduces employment-related issues that can complicate negotiations and resolution efforts.
This article explores the common causes of earnout disputes, strategies to prevent them, and best practices for resolving conflicts when they arise, with a focus on the unique challenges posed by management-held earnouts.
1. Understanding the Root Causes of Earnout Disputes
Earnout disputes typically arise from the following issues:
- Ambiguity in Earnout Terms: Vague or poorly drafted earnout provisions can lead to differing interpretations of performance metrics, timelines, or calculation methods.
- Operational Control Conflicts: Sellers may allege that the platform company’s management decisions negatively impacted the acquired business’s performance, thereby reducing or negating the earnout payment. This can be exacerbated when management faces unexpected integration challenges that can distract from the initial growth of the business.
- Accounting Disputes: Differences in accounting practices or financial reporting can result in disputes over how earnout targets are measured.
When the earnout recipient is also part of the management team, additional complications arise:
- Employment Agreement Conflicts: Disputes over earnout payments can spill over into employment-related issues, such as claims of wrongful termination, breach of contract, or constructive dismissal if the manager argues their role or authority has been undermined.
- Dual Incentives: Management-held earnouts create a dual incentive structure where the individual’s financial interests (maximizing the earnout) may conflict with their fiduciary duties (maximize value to the shareholders) to the company.
- Retention Risks: If the dispute escalates, the manager may choose to leave the company, potentially disrupting operations and damaging relationships with key customers, suppliers, employees and other stakeholders.
2. Preventing Earnout Disputes: Proactive Strategies
To minimize the risk of disputes, private equity-backed platform companies should adopt the following strategies during the deal negotiation and integration phases:
- Draft Clear and Detailed Earnout Provisions: Ensure that the purchase agreement clearly defines the earnout metrics, calculation methods, timelines, and any exclusions or adjustments. Avoid vague language that could lead to differing interpretations. Incorporate detailed mediation, arbitration, or expert determination clauses in the purchase agreement to provide a structured process for resolving disputes.
- Harmonize Earnout and Employment Terms: Ensure that the employment agreement and earnout provisions are aligned and address potential conflicts, such as the manager’s role, authority, and performance expectations. Consider including provisions that address scenarios where the manager leaves the company before the earnout period ends, ensuring clarity on forfeiture or clawback of earnout payments.
- Align Expectations with Sellers: Engage in open and transparent discussions with sellers about the earnout structure and how it aligns with the business’s growth trajectory. Be realistic about the integration process and challenges the parties might face in the initial phase of the earnout.
- Document Operational Decisions: Maintain thorough records of post-acquisition decisions and their rationale to demonstrate that any changes were made in good faith and in the best interest of the business, consistent with any negotiated earnout covenants.
- Retention Incentives: Structure the earnout to incentivize the manager to remain with the company and contribute to its success, while also protecting the company’s interests. Earnouts are a great way to do this, but have a backup plan. What if it becomes clear in the first six months that the earnout is unattainable? Consider reserving other equity incentives. If it becomes clear the seller/manager is not a fit with management, begin documenting any potential performance issues or breaches of their employment agreement.
3. Resolving Earnout Disputes: Best Practices
When disputes arise, platform companies should take a strategic and collaborative approach to resolution:
- Engage Early and Constructively: Address disputes as soon as they emerge to prevent escalation. Open lines of communication with the seller can often lead to a mutually acceptable resolution. Assess whether retaining the manager is in the company’s best interest and, if so, explore creative solutions to resolve the dispute while keeping them engaged.
- Leverage Data and Documentation: Use financial records, operational data, and contemporaneous documentation to support your position and demonstrate compliance with the earnout terms.
- Involve Legal and Financial Experts: Work with experienced M&A attorneys and financial advisors to assess the merits of the dispute and develop and document a strong case. Carefully address employment-related concerns separately from the earnout dispute to avoid conflating the two and escalating tensions.
Earnout disputes can be unnecessarily complex and costly, but with careful planning and proactive management, private equity-backed platform companies can mitigate risks and achieve successful outcomes. By drafting clear earnout provisions, maintaining open communication with sellers, and leveraging expert guidance, platform companies can avoid or navigate disputes effectively and preserve the value of their acquisitions.
When the earnout recipient is also part of the management team, the stakes are even higher, as employment-related issues can further complicate matters. Addressing these challenges requires a nuanced approach that balances legal, financial, and operational considerations.
