Crafting Enhanced Earnout Structures in Today's Merger and Acquisition Scenario
Earnouts, a common feature in Mergers and Acquisitions (M&A) deals, are critical tools for reconciling valuation disparities between buyers and sellers. However, they can also lead to disputes and litigation if not handled with care.
Challenges in Earnout Negotiations
Negotiating and drafting earnouts can be complex, with common challenges including bridging valuation gaps amid market uncertainty, ambiguity in earnout provisions, and the impact of post-closing operational changes by buyers on earnout calculations. Disputes often rest on different assumptions and perceptions about the business before and after the sale.
Best Practices for Drafting Earnouts
To mitigate these challenges, best practices include careful and precise drafting of earnout provisions to avoid ambiguity. Parties should explicitly outline the buyer’s decision-making authority and how operational or strategic changes post-closing will impact earnout calculations. Including well-defined "efforts" covenants, such as requirements for the buyer to use "commercially reasonable efforts" or "best efforts" to meet earnout goals, helps manage expectations and provides grounds for claims if commitments fail.
Objective standards, such as third-party milestones, are recommended to reduce the likelihood of earnout disputes. Cooperation clauses and specifying cost responsibilities during due diligence can also reduce friction. Careful attention to contractual protections and ensuring all parties are aware of the potential risks can help avoid disputes and litigation.
Current M&A Climate and Earnouts
The reliance on earnouts has increased in recent years, with the average transaction multiple from 2022 to 2024 averaging 9.8, a decline from the 11.9 average from 2016-2021. This underscores the importance of earnouts in current M&A climates.
Earnout Trends in 2024
In 2024, earnouts were part of 22% of all M&A deals, excluding the life sciences sector. The median earnout length for deals struck in 2024 was 24 months, with a shift toward shorter performance periods. Sellers should get to know the buyer, including their management, business track record, and treatment of other acquisitions.
Earnout Litigation and Dispute Resolution
Despite the trend of moving away from certain clauses, the demand for earnouts persists. Delaware courts have seen an increase in earnout litigation, with disputes centering on whether earnout targets were satisfied. Dispute resolution venues, such as courts, arbitration, or designating experts, should be carefully considered for each deal.
Case Study: Fortis Advisors LLC v. Johnson & Johnson
In a notable case, the seller prevailed in the Sept. 4, 2024, decision in Fortis Advisors LLC v. Johnson & Johnson, securing damages of over $1 billion for a buyer's failure to use commercially reasonable efforts (CREs).
Alternatives to Cash-Based Earnouts
Equity may be an alternative to a cash-based earnout, providing alignment between buyer and seller on incentives and allowing the seller to see gains from growth in the overall business. Internal company metrics, like EBITDA, should be used with caution due to potential issues with human judgment calls and manipulation.
The Role of Equity in Earnouts
Using equity as currency may reduce the likelihood of conflict, serving as a cushion to the seller if other benchmarks are missed. Earnouts in 2024 utilized a handful of popular covenant and diligence standards, with only 10% or fewer of deals including a covenant to run the business in accordance with seller's past practice or a CRE standard.
The Delaware Chancery Court's Views on Earnouts
The Delaware Chancery Court has adopted views on specific medical reimbursement rates in an earnout case, following nearly five years of litigation. This underscores the importance of clear and precise drafting in earnout provisions.
In conclusion, earnouts continue to be critical tools in M&A negotiations but require thorough negotiation and legal care to define financial metrics, effort obligations, cooperation scopes, and risk sharing to minimize conflicts and litigation risk.
- In Mergers and Acquisitions (M&A) deals, earnouts are commonly used to reconcile valuation disparities, but they can lead to disputes and litigation if not managed carefully.
- Negotiating and drafting earnouts can be complex, with challenges such as bridging valuation gaps, ambiguity in provisions, and post-closing operational changes affecting earnout calculations.
- To mitigate these challenges, best practices include precise drafting, outlining the buyer’s decision-making authority, and specifying earnout goals with well-defined "efforts" covenants.
- Objective standards, cooperation clauses, and specifying cost responsibilities during due diligence can help reduce disputes and litigation.
- In recent years, the reliance on earnouts has increased, with the average transaction multiple averaging 9.8 for 2022-2024, underscoring their significance in current M&A climates.
- In 2024, earnouts were part of 22% of all M&A deals, excluding the life sciences sector, with the median earnout length being 24 months and a shift toward shorter performance periods.
- Despite a trend of moving away from certain clauses, the demand for earnouts persists, with Delaware courts seeing an increase in earnout litigation over earnout targets.
- Alternatives to cash-based earnouts may include equity, providing alignment between buyer and seller on incentives, but internal company metrics, like EBITDA, should be used with caution due to potential issues with human judgment calls and manipulation.
- Using equity as currency for earnouts may reduce the likelihood of conflict, serving as a cushion to the seller if other benchmarks are missed.
- The Delaware Chancery Court has adopted views on specific medical reimbursement rates in an earnout case, emphasizing the importance of clear and precise drafting in earnout provisions.
- In conclusion, earnouts are essential tools in M&A negotiations but require thorough negotiation, legal care, and precise drafting of financial metrics, effort obligations, cooperation scopes, and risk-sharing to minimize conflicts and litigation risk.
