Earnouts in Private Company M&A Transactions

The inclusion of earnout provisions in mergers and acquisitions involving private companies have become a rising trend in recent years. Earnouts help bridge the valuation gap between buyers and sellers by making a portion of the deal consideration payable later based upon a seller’s future performance. The increase in earnout provisions in M&A deals may be a reflection of the challenging M&A financing environment of recent years marked by high interest rates. Earnout payments are most common in merger transactions involving a private company seller and in deals involving private equity firms.

Earnouts reduce the amount that buyers pay upfront. The buyer will typically pay most of the amount upfront at closing and then agree to pay an additional amount at a specified future date if the seller achieves certain financial, regulatory, or operational metrics. The earnout amount is typically about 30% of the amount that the buyer pays at closing. Earnouts help reduce the risk of the buyer overpaying in situations where the seller’s future performance is uncertain or contingent on factors that are difficult to predict.

The earnout-related buyer covenants in merger agreements are often structured to require the buyer to use reasonable efforts to operate the business during the earnout period to achieve the earnout conditions. A reasonable efforts standard is more common when the buyer is a strategic buyer, rather than a financial buyer. When a financial buyer is involved, the buyer covenant may instead be worded to require the buyer to operate the business consistent with past practices during the earnout period.

While earnout provisions are predominantly found in deals involving a private company seller, the equivalent tool in a public company context is a contingent value right, or CVR. CVRs are functionally similar to earnouts. They are especially common in public company deals involving life sciences companies since future success can be highly dependent on future clinical trial results and regulatory approvals.

While earnout provisions offer both parties a number of advantages, earnout disputes can lead to litigation following the closing of a merger. A lot of earnout disputes focus on whether the buyer actually used reasonable efforts to operate the acquired business post-closing in a manner that supported achievement of the earnout payment. The seller in such disputes will claim that the buyer’s actions during the earnout period frustrated the achievement of the earnout payment.

Historically, courts have tended to rule in favor of the buyer, finding that the buyer had legitimate business reasons for how it decided to run the business and highlighting the need for the buyer to have decision-making discretion. Since the pandemic, courts decisions have become more favorable to sellers. However, it is important to note that these cases are heavily dependent on the particular facts and circumstances in play in each situation.

In the 2023 Delaware case FMLS v. Integris BioServices, the Delaware Court of Chancery founded that the buyer’s delays following the closing of the merger transaction to hire new scientists were intended to prevent the earnout targets from being reached. The court held that the buyer acted with a bad faith intent to cause the acquired company to miss specified revenue targets required for the earnout payment in the months following the merger closing.

In another recent Delaware case, Shareholder Representative Services v. Albertson’s, the Delaware Court of Chancery found that the buyer’s actions had been partly motivated by an intent to avoid the earnout payments. The dispute arose from a merger agreement entered into between Albertsons Companies and Plated, an internet meal-kit provider. After the merger closing, the seller claimed that Albertsons had immediately shifted the focus of the acquired company’s business from e-commerce sales to in-store sales. The earnout was based on the acquired company’s e-commerce operations achieving specified revenue milestones. The Delaware Court of Chancery concluded that it was reasonably probable that Albertsons had intentionally shifted the post-closing business model in order to avoid the earnout milestones from being satisfied.

Companies thinking about including an earnout provision in their merger agreement should take into account a number of practical considerations. Clear, unambiguous legal drafting is crucial. The earnout provision should specify in detail the metric(s) being used with respect to measuring achievement of the earnout and the process for calculating the earnout as applicable. The parties should also make sure the earnout provision interacts properly with other provisions in the merger agreement.

In addition, the parties should keep in mind that, in the event of future earnout disputes, the parties’ intentions at the time of crafting the earnout provision may be used as evidence. For example, revisions and comments exchanged between the parties on merger agreement drafts may be reviewed by a court and be used as evidence about the understanding the parties had at the time with respect to the earnout.