When a private equity (PE) firm buys the controlling interest in a private business, the purchase often includes an earn-out provision which calls for the owner to remain active in the business for some period of time. The use of an earn-out provision can seem like a win-win for both parties, because it allows the PE firm to buy the company for a lower purchase price and provides the business owner with the opportunity to secure a substantial additional payment if the company achieves certain agreed financial performance targets after the sale.  The problem with this rosy picture is that earn-out provisions are a common cause of disputes and litigation over whether the earn-out requirements were met after the purchase and whether the owner is entitled to the additional payment.

This post focuses on conflicts that frequently arise between PE firms and owners over earn-out provisions and suggests changes for both PE Firms and owners to consider, which may reduce or eliminate these post-purchase conflicts.  

Refine the Earn Out Formula Used in the Earn-Out Provision

The obvious starting point is to draft an earn-out formula that is both simple and easy to apply, but surprisingly, disputes remain common regarding the manner in which the earn-out provision should be interpreted. The following guidelines are therefore offered regarding the specific terms the parties include in the earn-out provision, which may help avoid at least some of the frequent post-purchase disputes between the PE firm and the business owner.

• First, the contingent payment that is available to the former owner under the earn-out provision should be based on the company’s revenues, not earnings. Earnings can be subject to manipulation, and disputes are less likely when the company’s revenues are used as the measuring stick in the earn-out formula.
• Second, some earn-out provisions present the business owner with an all or nothing scenario – the owner receives a future payment if and only if a certain revenue target is achieved after the sale. This form of an earn-out provision invites conflict, because it may result in the former owner receiving no additional payment if the target is not met. Disputes may therefore be avoided if the annual earn-out payment issued to the former owner is based on a percentage of the company’s revenues after the sale. The use of this type of revenue formula assures the former owner of receiving at least some additional payment after the sale in addition to the original purchase price.
• Finally, the parties should consider requesting a third party, such as an independent accounting firm, to determine whether the terms of the earn-out provision have been met after the purchase concludes. Using an independent third party to make the determination regarding the earn-out provision gives the process an authenticity that is much harder to refute.

Detailing Owner’s Role After Purchase and Including a “For Cause” Provision

It is not uncommon for a former owner to change his or her behavior after selling the business to the PE firm, which can happen when the owner realizes that he/she is no longer calling all of the shots at the company. Part of the problem here may be that the terms of the purchase agreement failed to adequately define the owner’s role and responsibilities after the sale to the PE firm.  The result may be that the owner does too much or too little at the company.  In some cases, the former owner’s behavior becomes so problematic or dysfunctional that the PE firm concludes that the owner needs to be removed for the good of the company.

The PE firm may not be permitted to terminate the company’s post-purchase employment agreement with the former owner after the purchase, however, because the owner’s removal may not be permitted or even contemplated by the purchase agreement. To address issues related to the owner’s misconduct after the PE firm’s purchase of the business, therefore, the purchase/sale agreement should include both: (a) a clear description of the owner’s duties for the company after the purchase and (b) a “termination for cause” provision that will permit the PE firm to terminate the former owner’s employment for cause after the purchase is completed.  Adding these provisions in the purchase agreement provide the former owner with guidance regarding the former owner’s specific duties and role after the PE firm’s purchase of the company, but they also give the owner of the private equity firm the right to terminate the former owner’s employment if warranted for cause.

Use Mandatory Arbitration for Fast Track Resolution of Disputes

Given the frequency of post-purchase disputes between PE firms and former owners related to earn out provisions, the parties should consider including a conflict resolution process in the purchase agreement. In this regard, we recommend that the parties include a fast-track arbitration provision to resolve all disputes.  A fast-track arbitration provides the parties with all of the following benefits:

• Confidentiality – all disputes are handled privately outside of court
• Limited discovery – the provision includes specific limits on depositions and all other types of pre-hearing discovery
• Prompt Hearing Date – the hearing will take place within 90 days
• Finality – all rulings of the arbitration panel are final and unappealable
• Enforceability – arbitration rulings can be enforced by any court

Conclusion

The use of an earn-out provision in a purchase agreement provides the PE firm and the business owner with a potential win-win outcome in the purchase of the private company. This positive aspect of the earn-out is fully achieved, however, only if the provision does not lead to costly disputes and prolonged litigation between the PE firm and the former business owner after the purchase of the company has been completed.  Given the frequency of post-purchase disputes that arise regarding earn-out provisions, a new approach to these provisions seems warranted.  These post-purchase disputes may be avoided or resolved in a prompt, cost-effective way if the parties consider making the changes to the form of the provision discussed in this post and if the parties also include a fast-track arbitration provision in the purchase agreement.