Share Purchase Agreements (SPAs) are essential documents that govern the private sale and purchase of shares in a company. Increasingly, these agreements include earn-out mechanisms, which, while valuable, often lead to disputes regarding their interpretation and enforcement.
What Are Earn-outs in Share Purchase Agreements?
Earn-out provisions are frequently included in SPAs to align the interests of buyers and sellers, especially in cases where the selling shareholder remains as a director and continues working for the company post-sale.
Typically, an earn-out structure involves the buyer paying an initial fixed amount at completion, with further payments contingent upon the target company meeting predefined milestones. These milestones often relate to revenue targets, EBITA thresholds, or other key performance indicators (KPIs).
The inclusion of an earn-out clause can benefit both parties by:
(a) returning value to the seller if the target company exceeds its targets, and
(b) incentivising seller stakeholders to remain involved and committed to the performance of the business even after the completion of the sale.
Common Causes of Earn-out Disputes
Earn-out disputes often arise from several common factors:
Ambiguity in Wording: Vague or poorly defined terms can lead to disagreements over whether the conditions of the earn-out provision have been met. For instance, disputes frequently arise over the definition of key financial metrics, the accounting standards to be used, and the specific methodology for calculating the earn-out.
Operational Control Post-Completion: Disputes may also arise concerning how the company is managed after the acquisition. Sellers may argue that the buyer has taken—or failed to take—actions that undermine the achievement of earn-out targets, either deliberately or negligently. On the other hand, buyers may assert that their management decisions, even if they negatively impact the earn-out, are within their rights and in the best interest of the business. For example, a significant change in the company’s business strategy could impact performance metrics.
Disagreements over Financial Reporting: As earn-out payments are often tied to financial performance, disputes inevitably arise over financial reporting. This includes issues such as revenue recognition, cost allocation, and adjustments for extraordinary items. Arguments often revolve around whether improper accounting principles were adopted, thereby misrepresenting the company’s performance.
Timing of Earn-out Payments: The timing of earn-out calculations and payments is another area of contention. Disputes can arise over when the earn-out period begins, how long it lasts, and when payments are due.
How to Avoid Earn-out Disputes
To mitigate the risk of earn-out disputes, consider the following steps:
Clear and Precise Drafting: Ensure that the SPA contains clear and detailed drafting. All key terms, including financial metrics, calculation methods, accounting standards, and timelines, should be clearly defined. Where possible, include illustrative examples to show how the earn-out will be calculated.
Third-Party Review and Auditing: To avoid disputes over financial calculations, the SPA could prescribe an independent third-party auditor to review the company’s financial statements used to calculate the earn-out. Independent verification often provides both parties with greater confidence in the accuracy of the calculations.
Addressing Post-Completion Control: The SPA should address how the company will be managed post-completion, particularly if the seller remains involved. Establishing clear guidelines for decision-making authority and operational control can help prevent disputes over actions that may impact the earn-out.
Establishing Governance Mechanisms: Including specific governance mechanisms in the SPA, such as an earn-out committee to oversee the achievement of earn-out targets, can foster transparency and communication, helping to mitigate potential disputes.
Dispute Resolution Mechanisms: Incorporate specific dispute resolution mechanisms within the SPA, such as mandatory mediation, arbitration, or the involvement of experts. These measures can provide a more efficient and cost-effective way to resolve earn-out disputes.
Share Purchase Agreement Dispute Litigation: Contact Us
If you need advice or assistance with navigating disputes related to share purchase agreements, including those concerning earn-out provisions, please contact Partner Jonathan Chan at j.chan@rfblegal.co.uk.
Jonathan Chan
Litigation Partner
