Share Purchase Agreements (SPAs) are pivotal documents in the sale and purchase of shares in a private company. Increasingly, these agreements feature earn-out provisions—mechanisms designed to bridge valuation gaps and align the interests of buyers and sellers. However, without careful drafting and clarity, earn-out clauses can often lead to disputes, complicating what should be a mutually beneficial arrangement.
What are earn-outs in Share Purchase Agreements?
Earn-out provisions are price adjustment mechanisms frequently used when the seller remains involved in the business post-sale, such as in a director or stakeholder role. They enable buyers and sellers to negotiate a fair purchase price based on the company’s future performance.
Typically, earn-outs involve an initial payment upon completion of the sale, followed by additional payments contingent on achieving predefined milestones, such as:
- Revenue targets
- EBITA thresholds
- Key performance indicators (KPIs)
Earn-out clauses benefit both parties by:
- Rewarding sellers if the business meets or exceeds agreed targets.
- Encouraging sellers to remain committed to the company’s success during the earn-out period.
Common causes of earn-out disputes
While earn-outs can create a win-win scenario, their inherent complexity often leads to disagreements. Common causes of disputes include:
Ambiguity in wording
Vague or poorly defined terms can result in differing interpretations of the SPA. Disputes often arise from:
- Lack of clarity in defining financial metrics.
- Ambiguities around accounting standards to be applied.
- Confusion regarding the methodology for calculating earn-outs.
Operational control post-completion
Tensions may emerge over how the business is managed after the sale. Sellers may argue that the buyer’s decisions hindered the achievement of earn-out targets, while buyers may assert that their management decisions, even if detrimental to the earn-out, are in the company’s best interests. Significant strategic shifts, for example, can impact agreed performance metrics.
Disagreements over financial reporting
Since earn-outs are linked to financial performance, disputes may arise over financial reporting practices. Issues often centre on:
- Revenue recognition
- Cost allocation
- Adjustments for extraordinary items
Buyers and sellers may clash over whether accounting principles were properly applied, or whether financial results were manipulated to distort performance.
Timing of earn-out payments
Disputes also arise from confusion over the timing of earn-out calculations and payments. Key considerations include:
- The start date of the earn-out period.
- The length of the earn-out period.
- When payments are due.
How to avoid earn-out disputes
Proactive measures during the drafting stage can significantly reduce the risk of disputes. Here are five best practices:
- Clear and precise drafting
Ensure that the SPA is meticulously drafted with unambiguous language. Clearly define all key terms, including financial metrics, calculation methods, accounting standards, and timelines. Where possible, include illustrative examples to demonstrate how the earn-out will be calculated. - Third-party review and auditing
Incorporate provisions for an independent third-party auditor to review financial statements used in earn-out calculations. This can enhance confidence and help resolve disagreements. - Addressing post-completion control
Clearly outline the operational structure post-sale, particularly if the seller remains involved. Specify decision-making authority and governance protocols to minimise conflicts. - Establishing governance mechanisms
Consider creating an earn-out committee to oversee the achievement of targets and performance milestones. This fosters transparency and improves communication between the parties. - Dispute resolution mechanisms
Include tailored dispute resolution processes, such as mediation, arbitration, or expert determination, to address conflicts efficiently and cost-effectively.
Comment
Earn-out provisions can be an effective solution for reconciling valuation differences between buyers and sellers. However, they require careful planning and precise drafting to minimise disputes. By addressing common pitfalls and proactively incorporating governance mechanisms, parties can ensure a smoother transaction and foster a collaborative post-sale relationship.
At Nelsons, our experienced commercial litigation solicitors are here to help you navigate the complexities of SPAs and earn-out provisions. Whether you’re drafting an agreement or resolving a dispute, we provide clear, tailored advice to safeguard your interests.
How can we help
Andy Rudkin is a Partner in our expert Dispute Resolution team, providing specialist advice on partnership and company disputes.
If you have any concerns then please get in touch with Andy or another member of the team in Derby, Leicester or Nottingham on 0800 024 1976 or via our online enquiry form.
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