May 23, 2005

Caveat Earnoutor

Everyone knows that even the most elegantly drafted earnout provisions can generate some unintended consequences in their actual implementation. A common earnout scenario involves the requirement that (i) at least one of the target’s officers (the “TO”) be an officer of the buyer (usually in charge of running the post acquisition target) and (ii) an audit be conducted by the buyer’s independent public accounting firm (the “BIPA”) regarding some or all of the earnout period. What many TOs don’t contemplate is that, as an officer in charge of the target’s post acquisition operations, the BIPA is, in all likelihood, going to require the TO is sign the BIPA’s management representation letter (“MRL”) as a prerequisite to the BIPA releasing the audit. The problem here is that the buyer may take positions regarding certain accounting issues regarding the earnout that the target would like to dispute, but with the TO signing the MRL, the target has at least tacitly concurred with the BIPA’s and buyer’s accounting treatment, thereby leaving the target to argue “I know I signed the MRL saying that I concurred with everything in the MRL and that everything in the MRL was accurate but now that we’re having this earnout discussion I disagree with some of the items I previously said I agreed with in the MRL…” Of course, the parties can agree that the MRL isn’t going “to be used against the target in any dispute” but the optics are difficult and you have to deal with the issue of inherent bias created with the mere presence of the TO’s signature to the MRL. The real solution is to have the parties agree when the deal is signed up that the TO will not have to sign a MRL. Because the BIPA can be the real stumbling block here (i.e., refusing to release the audit without a fully executed MRL) it’s a good idea to get them onboard at the same time.