The earnout fallout

One consequence of the recent economic crisis has been a substantial increase in the use of earnout provisions in merger and acquisition agreements. This increase in earnout provisions will likely result in numerous post-acquisition disputes that may have significant economic implications for both buyers and sellers.

Earnout provisions are often utilized to bridge the gap between the buyer's and the seller's differing views regarding the value of the business to be sold. Earnout provisions often contain financial metrics that must be calculated before the amount of the earnout payment can be determined. Agreements commonly contain language requiring that financial targets be determined in accordance with generally accepted accounting principles, or GAAP, applied on a consistent basis with past practice. If the financial targets are met, the seller is entitled to receive the earnout payment.

GAAP is a compilation of the standards, conventions and rules commonly utilized in preparing financial statements. Many accounting-related issues in earnout disputes, as well as other post-acquisition disputes, involve a disagreement regarding the estimates and judgments inherent in following GAAP. For example, the buyer of a business might increase the reserve for doubtful accounts (the accounts receivable that the buyer estimates will be uncollectable), which results in additional bad debt expense, thereby decreasing the business' earnings. This adjustment could result in the earnout payment decreasing by a multiple of the additional expense, or even completely eliminated. Adjustments such as these are often disputed by the seller, especially when they are recorded by the buyer near the end of the earnout period.

In arguing its position, the buyer often points to factors that support the additional reserve, such as the fact that the nature of the business itself has changed or that the customers have not paid the amounts they owe. The seller often points to the language of the M&A agreement requiring that the financial statements be prepared on a basis consistent with past practice and may claim that the buyer recorded the adjustment for the sole purpose of decreasing the earnout amount.

Aside from accounting issues, the parties often disagree as to whether the business was appropriately operated during the earnout period. At the time the M&A agreement is negotiated, the parties often have differing agendas as to the future operations of the business. In many instances, the seller wants the business to be operated similarly with past practice. The buyer often has new ideas as to how it wants to operate the business in order to grow the business and to increase profitability. The buyer's plan often requires the business to incur expenses that may decrease earnings during the earnout period. If the buyer alters the historical operations of the business and the earnout benchmarks are not met (which may be more likely to occur during a recession), the seller may dispute the buyer's business judgment and question whether the expenses incurred were appropriate. Often the seller claims it would not have incurred such expenses. These types of disputes often center on the clarity with which the parties' intentions and understandings regarding the future operations of the business are spelled out in the M&A agreement.

Unless the M&A agreement clearly prohibits particular expenses from being considered in the determination of the earnout, the buyer will often argue that there is nothing in the M&A agreement that prevents it from operating the business as it sees fit. The seller, however, may point to the language in the M&A agreement that requires earnings to be calculated on a basis consistent with past practice and argue that the expenses in question were not consistent with past practice because they were not the types of expenses that the seller had historically incurred.

A difficult business climate at the time the transaction was negotiated may make parties more likely to defer a significant portion of the purchase price in the form of an earnout subject to the achievement of specified financial metrics. Although a challenging economic environment may encourage a buyer to incur expenses that differ from past practices in order to stimulate revenues, those expenses may meet with only limited success. These factors -- while by no means exhaustive -- point to an increased likelihood of post-acquisition disputes centering on earnout disputes.

Jeffrey M. Katz is partner and practice leader of BDO Consulting's Post-Acquisition Dispute Resolution Services Practice.