September 5, 2019

The Trouble With Earnouts

I really like this Cooley blog, because to me it gets to the heart of the problem with using earnouts to bridge the valuation gap:

Often discussed in the context of bridging a valuation gap, an “earn-out” can be a (seemingly) attractive solution for parties who have reached agreement on everything but the purchase price. Earn-outs can take many different shapes, but the basic concept involves a seller receiving a promise of additional consideration from buyer in the future if certain agreed upon milestones are achieved.

Call it a compromise, call it delayed gratification, but do not call it simple: earn-out payments often give rise to disputes because the interpretation of what qualifies as the achievement of previously negotiated milestones can differ wildly once viewed through the muddied lens of time. With each party economically incentivized post-closing to adopt a reading that exploits any ambiguity to its benefit, and no reliable narrator to remind the parties of their prior positions, many bridges are burnt.

The blog then recounts the story of two recent Delaware decisions that are in keeping with the “dysfunctional Goldilocks” conclusions that courts usually reach when addressing ambiguous earnout provisions – this one’s too hot, this one’s too cold, and there’s never one that’s just right. In the end, the blog suggests that the best thing way to bridge the valuation gap may be to agree on value in the first place.

John Jenkins