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Earnout protection mechanisms for business sale agreements

Author: Craig Sanford, DIrector

In a post a couple of weeks ago (click here), I gave 5 tips for sellers of businesses in relation to earnouts. As most of you will know, an earnout is the right of a seller to receive additional compensation in the future if the business that was sold achieves certain financial goals after completion of the sale (e.g. earnings over a specified threshold level).

In this week’s post, I suggest some specific earnout protection mechanisms that sellers could try to include in business sale agreements that contain earnout provisions. You will be unlikely to get away with all of these protections as a seller, but the more the better for a couple of reasons:

  1. You will hopefully increase the potential amount of the earnout … and the likelihood of being paid by the buyer.

  2. If the relationship between the seller and buyer breaks down during the earnout period (which in my experience isn’t unusual!), then the more control and other protections you have as a seller in the business sale agreement, the more negotiating power you will have in negotiating a favourable alternative arrangement with the buyer.

So here are some of my suggested earnout protections for sellers:

1. Try to retain some control over the business post-sale

One of the best ways to protect yourself as a seller in relation to an earnout, is to retain as much control as possible over the way the business is run after completion.

This could include retaining one or more board seats and/or a shareholding in the company that conducts the business.

Where a shareholding is retained, a shareholders agreement would ideally be entered into. This agreement could give the seller an opportunity to gain even more control during the earnout period – for example, the agreement could specify a list of significant decisions where the unanimous approval of shareholders is required.

The business sale agreement could also contain a number of other controls for the seller – a few of these are suggested below.

2. Ask buyer to comply with specific obligations during earnout period

As the seller, you should try to require the buyer to comply with a number of positive obligations in the operation of the business in order to maximise and protect your earnout.

These obligations could include a requirement in the business sale agreement that the buyer, during the earnout period:

  • acts in good faith in all of its dealings with, and in relation to, the seller and the business;

  • conducts the business in substantially the same manner as it was conducted by the seller during the 12 months leading up to completion;

  • ensures that the business maintains all existing customer and supplier relationships to the extent that they are in the best interests of the business;

  • maintains costs and expenses of the business at a level that does not materially exceed the level of costs and expenses incurred in the past by the Company; and

  • ensures that the company is treated as a separate entity for accounting purposes, operating at arm's length from any related entities of the buyer.

3. Ask buyer to comply with “negative covenants” during earnout period

In addition to the above obligations, as the seller, you also should try to require the buyer to comply with a number of “negative covenants” in the operation of the business during the earnout period. In other words, the business sale agreement should prohibit the buyer from doing a number of specified things during the earnout period in the conduct of the business (without getting the prior written consent of the seller), such as:

  • materially changing the nature or scale of the business or the manner in which the business is conducted;

  • anything which:

    • is not in the ordinary course of the business;

    • has the intention of reducing the revenue or earnings of the business;

    • is in breach of any contract to which the company is a party (including any shareholders agreement entered into between the buyer and the seller in relation to the company); or

    • has the intention of diverting opportunities (within the scope and capabilities of the business) to any related entities of the buyer;

  • disposing of the business, all (or any material part) of the assets owned or used in the business, or any shares or other securities in the company;

  • passing a resolution to wind up the company or to cause the company to stop carrying on any part of the business;

  • charging the business for goods or services provided by the buyer or any related entity of the buyer, other than reasonable charges based on the services provided, or arm’s length charges to be agreed with the seller;

  • entering into any contract outside of the ordinary course of the business, or which is not on arm’s length terms;

  • sub-contracting or otherwise transferring any revenue-generating activity of the business to another entity; or

  • delaying or deferring the recognition or bringing to account of any revenue or profits by the company, or bringing forward any expenses of the company, in a manner which is contrary to the agreed accounting policies of the company.

4. Provide for specific compensation for buyer’s breach

The business sale agreement should make it clear what happens if the buyer breaches any of the above earnout obligations and negative covenants. This will hopefully provide a stronger incentive for the buyer not to deviate from its obligations.

For example, the agreement could state that if the buyer breaches, and the seller reasonably believes that the buyer’s breach has had an adverse effect on the potential earnout amount payable to the seller, then:

  • the seller can appoint an expert to determine the amount by which the earnout amount is likely to have reduced as a result of the buyer’s breach; and

  • this amount would be added to the actual earnout amount payable to the seller after the end of the earnout period.

5. Ask for an “accelerated earnout” if the buyer seriously misbehaves

When acting for a seller, I often try to include an “accelerated earnout” provision in the business sale agreement, as a further incentive for the buyer not to deviate from its obligations.

An “accelerated earnout” provision will state that if certain specified events occur during the earnout period, then the earnout period will be taken to have ended and the calculation and payment of the earnout amount will be immediately brought forward. Some of these specified events may include:

  • the buyer failing to maintain any required earnout security for the duration of the earnout period;

  • the buyer or the company committing a material breach of the business sale agreement (or of any shareholders agreement) that is not capable of remedy or that has not been remedied within a specified period;

  • an insolvency event occurring in respect of the buyer or the company;

  • a change of control occurring in relation to the buyer or the company (or the buyer otherwise ceasing to be a shareholder of the company); or

  • any employment or consultancy agreement under which the seller (if an individual) or a director of the seller (if a company) is employed or engaged by the company during the earnout period, is terminated by the company, other than by mutual consent or on grounds justifying termination with immediate effect.

6. Include detailed principles for calculating the earnout amount

The business sale agreement should include detailed principles for calculating whether, at the end of the earnout period, the relevant financial goal(s) for the earnout payment (e.g. earnings above a certain level) have been achieved.

The basic idea with these principles is to ensure that this calculation is made on a reasonable basis, including the exclusion of “abnormal” expenditure and other items from the calculation. For example, if the business is being sold into a large corporate group, the principles should make it clear how to account for head office expenses charged to the business.

Make sure you get an accountant experienced in M&A to prepare these earnout principles.

7. Ask for security for the earnout payment

The buyer would ideally be asked to provide some form of security for the earnout payment.

There are a number of different security mechanisms that I have got away with in the past, but a common one I use is a simple guarantee and indemnity from another company of substance that is a related body corporate of the buyer, and possibly even a personal guarantee and indemnity from one or more directors or shareholders of the buyer.

In summary, the key to earnout provisions for a seller is to maximise the number and extent of controls that the seller has over the buyer and the business during the earnout period, as well as providing for specific (and serious) consequences for the buyer if the buyer does not fully comply with these controls.