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Post M&A Disputes -- Earn-Outs and Claw-Backs and the Avoidance of Uncertainty

Mar 31, 2022

When the seller of a business or a business segment finally agrees to a purchase price with the buyer, it would appear, at least to someone on the outside, that the deal is done. Buyer pays seller, and everyone rides off happily into the sunset with either the proceeds of the deal or the aspirations of embarking on a successful business journey. However, there are two purchase price components that may be present and go beyond a simple exchange of cash and/or other predetermined consideration at closing -- and often take months, or maybe even years, to settle.

The first of these is a balance sheet metric, often tied to the closing working capital of the acquired business. Working capital, at its simplest, is the entity’s current assets minus its current liabilities – frequently modified to reflect certain characteristics of the purchase agreement (e.g., the exclusion of cash from being transferred from seller to buyer). Purchase-price adjustments related to working capital or other balance sheet metrics typically result from there being a difference between the actual balance sheet metric at closing and a contractually agreed upon “target” balance sheet metric agreed upon when the parties have agreed to the deal.

The other common purchase price adjustment type is based on the concept of an “earn‐out,” which is a methodology under which seller may benefit from the sold business’s post-transaction activity. Simply described, earn-outs are used to bridge gaps that may exist between the price a seller wants to receive for its business and the price a buyer is willing to pay. They provide a level of assurance regarding the reliability of the representations that are made during the deal-negotiation process.

Such a provision may be tied to a benchmark (either financial or non-financial) or governed by a formula (or some combination thereof). Examples of these types of provisions follow:

  • Non-financial benchmark: The seller is paid an additional $1 million upon the regulatory green light for a drug that was in the approval process at the time of the transaction.
  • Financial benchmark: The seller is paid an additional $2 million if earnings before interest, taxes, amortization, and depreciation (“EBITDA”) in the year following the transaction exceeds $5 million.
  • Financial formula: The seller is paid 20% of net income for the 24 months following the transaction date.
  • Financial benchmark/formula: The seller is paid 10% of the amount by which sales revenues in the 18 months following the transaction exceed $5 million.

Earn-out provisions may also be structured in reverse in what is commonly called a “claw-back,” under which the seller effectively bears some risk related to the entity’s post-transaction performance. A simple example is a contractual provision whereby the seller must refund to the buyer a portion of the purchase price if post-transaction EBITDA does not exceed $3 million in the first year.

The language of the governing transaction agreement will dictate how the financial-formula earn-out or claw-back amount, if applicable, is calculated. The applicable provision will most likely state that the relevant measure (for example, operating income) must be “prepared in accordance with GAAP,” but often provides for certain modifications – such as the inclusion of certain revenues in or exclusion of certain expenses from the calculation.

Additionally, the calculated amount may be subject to a ”cap,” or “collar,” limiting the amount of recovery by one party and corresponding liability of the other. For example, the agreement may state something like “the adjustment amount shall be limited to and not exceed the adjustment cap.” For example, a $1 million cap would limit a buyer’s claw-back recovery to that amount, even if the formulaic calculation would otherwise allow for it to be “refunded” a greater amount of the purchase price.

Because of the many potential nuances and potential consequences of the agreement’s wording regarding earn-out and claw-back provisions, it is critical that transaction parties and their counsel consult with accounting advisors who are experienced in such matters when crafting and reviewing purchase transaction agreements – not just when a dispute ensues down the road. Deals professionals with backgrounds in such contractual mechanisms can identify ambiguous language in the draft agreement that may lead to uncertainties and controversies when ”pen is put to paper” to perform the eventual calculations. These are avoidable issues.

Further, among the many lessons the pandemic has taught us is the necessity of providing for unintended consequences of unanticipated circumstances. “GAAP as consistently applied” (with the acquired entity’s historical practices) is the accounting convention often cited by transaction agreements regarding the basis of the measurement amount for earn-out and claw-back calculations. However, this basis of accounting does not, for example, clearly provide for the treatment in an earn-out or claw-back calculation of revenues or other inflows from sources that did not previously exist, or expenses or outflows related to costs or obligations that for which there is no precedent for the entity.

Accounting professionals with experience in the crafting of earn-out and claw-back structures – and in analyzing and resolving disputes surrounding them – can prove invaluable in the design of such provisions in a way that minimizes the impact of unforeseen occurrences. Buyers, sellers, and attorneys are therefore encouraged to leverage the advice of these experts as they contemplate the inclusion of these features – as well as balance sheet metric adjustment and dispute resolution language – as they draft deal documents.

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