How to harness the power of earnouts (and manage their risk)

Andrew Bernstein (00:07): Hi everyone. I'm Andrew Bernstein, and we're back with another of our video series on commercial disputes. Today, we're discussing a common type of dispute we see in the M&A context: earnout disputes. And I'm joined by my colleagues Gill Dingle and Alex Shelley from the Torys Litigation Department, who's going to tell us all about them. Alex, what are earnouts and how do they work?

Alexandra Shelley (00:28): Thanks, Andrew. We see earnouts in purchase agreements. Typically, an earnout is an agreement between a buyer and a seller of a business, where the seller can obtain an additional payment post-closing if the business later achieves predetermined performance targets. And often they contain some formulas that explain exactly how the earnout is going to work. And these can be straightforward, like 10% of earnings for the next 5 years, which is simple enough, or they can be complicated involving earnings thresholds and sliding scales.

Andrew Bernstein (01:00): Gill, why do people use earnouts?

Gillian Dingle (01:02): An earnout can be useful if parties are having difficulty at the negotiation stage reaching an agreement on the upfront cash price. The earnout is a way to bridge the different views on value as between the buyer and the seller. And so while the earnout is an effective way to bridge this gap, reliance on earnout sometimes just kicks the can further down the road when it comes to a dispute. And after closing, you find that you're engaged in a dispute about whether the earnout criteria was satisfied, and if in fact the earnout has to be paid. And so from our perspective as litigators, earnouts and post-closing adjustments are probably the two greatest sources of litigation arising out of purchase agreements because both require a post-closing exchange of funds. And we can really see this as a trend in the pandemic because as a result of the pandemic and the volatility that we saw in the markets, there were increased sales of non-core operations to raise capital, and earnouts tend to be more common where a company has a smaller operating history, there has been a temporary drop in earnings or the company is operating in a volatile economy, or where the purchaser has limited access to funds. And you can see how the pandemic would really trigger all of these scenarios. Earnouts can be useful in these scenarios as a means of bridging the gap.

Andrew Bernstein (02:27): Okay. Alex, take us through some disputes that happened in the context of earnings.

Alexandra Shelley (02:33): Sure. So I talked before about how generally an earnout provision works, but let's talk about how they're actually drafted. So typically an earnout provision will describe the following: you have the earnout target or threshold, and that can be either financial or non-financial, you have a mechanism for determining whether the earnout criteria has been met, then you have the type of earnout payment, so that can be a fixed fee—sort of a one-time lump sum—a formula-based calculation, so a sliding scale or percentage, and that's due only if the threshold is met, and then the last thing you have is the duration and the timing of the earnout payments. So as I mentioned, it could happen once or it could happen sort of every year for the next five years. And so really any of those can be disputed, but the most common disputes are disagreements about whether the earnout threshold, so whether that's revenue or earnings or some other metric, has actually been met. And Whiteside and Celestica International is a 2014 Ontario Court of Appeal decision which really embodies a classic earnout dispute. The dispute there was whether an earnout payment of $1.75 million, which actually exceeded the million dollar purchase price, was due and the dispute was over whether revenue from a large contract, which had been won post-closing, satisfied the four requirements that were set out for it to be included in the EBIAT, which was the earnings before interest amortization and tax calculation. And that calculation determined whether the earnout threshold had been met and whether the payment would be made. And the trial judge and the Ontario Court of Appeal actually came to different conclusions, which means there was room for two different interpretations in the share purchase agreement there. You can also actually see disputes arise as to whether all the steps have been met such that an earnout provision has been triggered. So one side might argue that the conditions for an earnout calculation to occur have been met, and an adjudicator should be appointed, and the other side may argue that certain necessary steps, for example the preparation of financial statements in a particular form, has not yet taken place. And so the court needs to decide whether the dispute is even ripe for adjudication with respect to earnout the payment.

Andrew Bernstein (04:37): Okay. Gill, it sounds like earnout disputes are messy and expensive, and ideally people would like to avoid them. So what should we consider while drafting a purchase agreement to minimize the likelihood of a future dispute?

Gillian Dingle (04:51): So if you feel that an earnout is going to be necessary to achieve the outcome that you want, the deal that you want, a couple of things to bear in mind. First, the target that you're trying to meet should be clear. So EBITDA, revenue, EPS, royalties, a hard clear target that's easy to measure. If there's going to be a non-financial target, again, easy to measure is key. Approval, obtaining a license, a certain number of new clients. And the target should be something that's not easily manipulated by either the buyer or the seller. So to try and avoid that moral hazard, you want to try and make it be a hard, measurable target. Some of that's hard to avoid because there are a lot of circumstances outside of the party operating the business, whether that's the seller or the buyer. There are a lot of circumstances outside of their control that could impact performance of the business. And there are mechanisms that are designed to exclude the impact of those external circumstances. But it does make the measurement difficult. And timing of the payment should be, if you can, reasonably close in time to closing. If you're talking about for example an 18-month period, the longer the timing is pushed out before the earnout target has to be met, the more likely it is that circumstances may occur that can be used by one side or the other that the target was or wasn't met for reasons outside of their control. And the last point to really consider when thinking about drafting an earnout provision in a purchase agreement is whether you're going to tie it to compliance with certain operating covenants. So parties will agree generally that the party who's continuing to operate the business, whether it's the buyer or the seller, needs to operate the business in the ordinary course. And that type of phrase common in purchase agreements, also unfortunately common in litigation because there are many arguments that can be had about whether a certain step was or wasn't in the ordinary course and the impact that that had on the ability to meet that particular earnout target. And so the final consideration is whether it actually makes sense to have an earnout clause at all, and this is really a business decision that drives your deal structure. The case that Alex mentioned, the earnout actually far outstripped the purchase price, so in a case like that, obviously there were business reasons militating in favour of the earnout. But if you're dealing with only a small earnout, it may not be worth the paper and the time and the expense of the fight down the road to have it.

Andrew Bernstein (07:39): Just saw it off in the middle and don't kick it down the road.

Gillian Dingle (07:42): There you go.

Andrew Bernstein (07:44): So Alex, what's the intersection between earnouts and good faith obligations?

Alexandra Shelley (07:49): It's a good question because it's been a developing area of the law recently. So we know since the Supreme Court's decision in Bhasin that good faith contractual performance is a general organizing principle of Canadian common law, and that parties to a contract or under a duty to act honestly in the performance of their contractual obligations—and that's all good and well. And more recently in 2021, we heard again from the Supreme Court in Wastech, and they clarified content of another doctrine flowing from the good faith organizing principle, which is the duty to exercise contractual discretion in good faith. And this duty applies to all contracts. The duty is breached only where the discretion is exercised unreasonably in a manner not connected to the underlying purpose for which the discretion was granted. Just this year in 2022, we saw the Ontario Superior Court consider in the earnout context whether a purchaser had breached its duty of good faith and honest performance of its contractual obligations, and its duty of good faith and honesty in the exercise of its discretion under a share purchase agreement. So it's become clearer that these duties do extend to earnouts, however good faith contractual performance doesn't require a party to "subvert" or "subordinate" its interests to those of the other party. So purchasers in Canada likely do not have to favour a seller's interest in achieving an earnout target, but they should be cautioned against actively working against the achievement of an earnout target. That's a no-no.

Andrew Bernstein (09:13): Okay, and I’m going to make a shameless plug. One of our videos series is going to be entitled "You've Got to Have (Good) Faith". And so we'll watch for that one. Gill, last question to you. Who adjudicates an earnout dispute?

Gillian Dingle (09:27): I don't have a "You've Got to Have (Good) Faith" pun to answer this one, but generally speaking, the adjudicator is set out in the purchase agreement and it depends on the earnout structure. If it's a clear, crisp financial target, it may be that either the CFO or an external independent accountant is going to be appointed by the parties to adjudicate. And hopefully it's a straightforward issue with limited litigation process around it. Generally speaking, the party not operating the business, whether that's the seller or the buyer, will have a right to consult, review, ask questions. There may also be a right to access records, which is something to bear in mind as that can sometimes be burdensome. And if there is a dispute that ultimately arises over the earnout, we've seen the adjudicator be the courts, arbitrators, an accountant, as I mentioned. And typically there will be a methodology in the purchase agreement setting out how the adjudicator is determined and what happens in the meta world, where there is a dispute about the dispute resolution person because that often happens. Recourses generally head to the courts in those circumstances.

Andrew Bernstein (10:45): Okay. Gill and Alex, thank you very much for joining us. We really appreciate you sharing all your insight on earnout disputes. That wraps up this session and we'll be back with our next session very soon. Thanks.

Gillian Dingle (10:56): Thanks everyone.

Alexandra Shelley (10:56): Thank you.