Earnouts in M&A Transactions

November 19, 2020 | Insights

The following article, adapted from a white paper written by Byron Egan and Zachary Ward, was contributed to the November 2020 issue of the Dallas Bar Association Headnotes. The opinions expressed are those of the authors and do not necessarily reflect the views of the firm, its clients, or any of its or their respective affiliates. This article is for informational purposes only and does not constitute legal advice.

By Byron F. Egan & Zachary P. Ward

An “earnout” is a deal mechanism used in a merger and acquisition transaction (“M&A Transaction”) which structures the terms upon which a buyer agrees to pay additional consideration to the seller after the closing of the M&A Transaction if certain specified performance targets are achieved post-closing by the acquired business or upon the occurrence of specific events. An earnout is a particularly useful deal mechanism when:

  1. the buyer and seller have differing views on the value of a business, which often is based on the estimated future performance of the business or the likelihood that a specific event will occur in the future, related to the acquired business;
  2. the seller will remain involved in the business post-closing, and the buyer wants to incentivize the seller to continue operating the business in a profitable capacity or grow the business after the closing of the M&A transaction;
  3. the acquired company experienced a drop in earnings prior to the M&A Transaction; or
  4. the acquired company is operating in a volatile economy or industry which can adversely affect the acquired company’s profitability or cause its value to fluctuate widely.

While earnouts are used to bridge disagreements that arise during the negotiation of the purchase price, earnouts commonly result in post-closing disputes over the calculation of the earnout. One of these disputes is exemplified by Fischer v. CTMI, L.L.C., where the Texas Supreme Court determined that an earnout provision that provided that a term relating to the amount of the final payment in a fouryear earnout “will have to be mutually agreed upon” at a future date, was not an unenforceable agreement to agree. 479 S.W.3d 231 (Tex. 2016).

In Fischer, the seller sold his business to the buyer, the buyer acquired accounts receivable on projects that the seller had not yet completed, and the parties agreed that the seller would be entitled to an earnout made each year from 2007 to 2010. While the 2007 earnout was a flat amount, the later three payments contained an “adjustment payment” equal to 30 percent of that year’s business revenue in excess of $2.5 million. The sole issue before the Supreme Court was an additional component in the 2010 earnout payment which, similar to the initial 2007 agreement, contained a “pending-projects clause” that obligated the buyer to pay the seller an amount based upon revenue from projects that were pending but not yet complete at the end of 2010. However, because the parties could not know in 2007 what projects would be pending completion in 2010, the pending-projects clause provided that the percentage of completion for each project “will have to be mutually agreed upon” by the parties. The trial court found the provision to be enforceable, but the court of appeals reversed.

In reaching its conclusion that the pending-projects clause was “sufficiently definite,” the Supreme Court began its analysis by outlining several fundamental contract principles:

  1. courts must evaluate the contract as a whole and may neither rewrite nor add to the parties’ language;
  2. Texas courts abhor forfeiture, and must construe a contract to avoid forfeiture if possible;
  3. when interpreting an agreement to avoid forfeiture, courts may imply terms where they may reasonably be implied;
  4. usage of trade and course of dealing may provide meaning to an otherwise imprecise term; and
  5. the parties’ performance may indicate they intended to be immediately bound by the agreement even when certain terms are indefinite.

The Court pointed out that where parties have done everything else necessary to make a binding agreement other than setting a price, “it will be presumed that a reasonable price was intended.” Further, the parties here did not fail to “reach some understanding as to price” or “provide an adequate way in which it can be fixed.” Rather, the parties provided a clear formula to calculate the payment by basing the amount on the percentage each project pending at the end of 2010 had been completed.

Perhaps most important in the Supreme Court’s conclusion, though, was the parties’ prior dealings and performance. When the parties entered into the purchase agreement in 2007, they allocated accounts receivable between them based on the percent each pending project had been completed at that time. Because of the parties’ prior dealings, the Court had no trouble concluding that when they agreed to the 2010 pending-projects clause, the parties “knew exactly how the process would work because they had just done it with then-existing accounts.” The Court read the 2010 pending-projects clause to require the parties to replicate the same “simple calculations” they had in 2007.

Fischer suggests that drafters may avoid inadvertently creating an unenforceable agreement to agree in their earnout provision by providing a formula for calculating inexact terms and substituting any promise to “negotiate” with a matter-of-fact statement that the parties will agree.