Disputes concerning earn-outs in M&A transactions case study. Małgorzata Surdek, CMS

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1 Disputes concerning earn-outs in M&A transactions case study Małgorzata Surdek, CMS

2 Earn-out: what is it? A mechanism of deferred payment of the purchase price until after the closing upon achievement of certain performance targets Helps to bridge a valuation gap between an optimistic seller and a cautious or cash strapped buyer However, a disagreement over the purchase price today may easily morph into a dispute over the target s performance in the future

3 Key earn-out provisions Definition of the acquired business Performance targets (financial & nonfinancial) Earn-out period Payout structure Future conduct of the business (allocation of control and level of support)

4 CMS European M&A Study 2015 Review of 2,400 deals in In % of deals included earn-out provisions Typical earn-out period: months (57% of deals) Most common earn-out basis: EBITDA (63% of deals)

5 Source of disputes over earn-out Most disputes are a result of the seller thinking the buyer manipulated the measurement of the target s performance or disagreement over calculations Sellers and buyers objectives may not be aligned it is important to agree the allocation of control between them postclosing and the buyer s level of support to the acquired business

6 Case study a PE transaction (1) A private equity fund acquired shares in a private company manufacturing diet supplements and some generic drugs SPA provided for a 24-month earn-out period based on certain financial and non-financial milestones Multi-tier DR mechanism: non-binding expert determination and ad hoc arbitration

7 Case study a PE transaction (2) Sellers brought an action against the PE fund arguing that the PE fund breached an implied good faith and fair dealing covenant by impeding the achievement of the earn-out through: discontinuing certain products removing key personnel from the acquired business failing to expend the resources to market the target s products terminating some distribution arrangements

8 Case study a PE transaction (3) The PE fund defense: these were legitimate business decisions and in any event claimants cannot rely on the implied covenant of good faith and fair dealing in the absence of express provisions to that effect in the SPA

9 Case study a PE transaction (4) The Arbitral Tribunal: confirmed the existence of the implied covenant of good faith and fair dealing (note the applicable substantive law!) looked into whether the PE fund had taken affirmative steps to achieve the earn-out (as opposed to simply not supporting the acquired business at a leval the sellers would prefer)

10 Case study a PE transaction (5) The Arbitral Tribunal (cont.): reasoned that the merits of the sellers claim depended on whether the PE fund had acted with a dishonest purpose, i.e. whether it had intentionally or recklessly caused the target to lose money found, based on the facts of the case, that the PE fund had made legitimate business decisions and that the sellers allegations were merely a dispute between sophisticated business people over what the appropriate strategy for the acquired business should be

11 Key take-aways for contract drafting (1) Buyers should seek to include wording which: negates any implied obligation with respect to the achievement of the earn-out and operation of the acquired business gives them absolute discretion over the operation of the acquired business

12 Key take-aways for contract drafting (2) Sellers should seek to include: restrictive covenants that explicitly prohibit certain actions affirmative covenants obligating the buyer to take certain actions provisions granting the seller some level of control over the acquired business during the earn-out period