November 14, 2023

When Earnouts Are Ambiguous: The Importance of a Good Record

John has blogged previously about the renewed reliance on earnouts in today’s uncertain environment. In fact, this Freshfields blog states that “one recent study found that the use of earnouts in U.S. private M&A deals in 2022 was higher than in any year since 2017.” But, as the blog notes, with more earnouts comes more earnout disputes “with the number of U.S. lawsuits involving earnouts nearly doubling between Q1 of 2022 and Q1 of 2023.”

Luckily, this litigation brings learning opportunities, and the blog describes how careful drafting can help reduce the chances of an earnout dispute. But, as we all know, clarity isn’t always achieved — or achievable. If the court concludes that a contractual term is ambiguous, it may look to external evidence submitted by the parties, which makes good record-keeping crucial. Here’s an excerpt from the blog:

Parties planning to use an earnout provision should practice good recordkeeping from the start of negotiations. A clear record of how the parties understood the terms of the earnout at the time of drafting may be crucial in a dispute, especially if the court concludes that a contractual term is ambiguous.

The Dematic case provides an example: there, the court held that the term “Company Products” was ambiguous and allowed the parties to introduce extrinsic evidence regarding how the products were made, the recommendations of the diligence team at the time of the transaction, and communications between the parties that reflected their understanding of the product at the time of signing.

In another recent case, Schneider Natl. Carriers, Inc. v. Kuntz,the agreement imposed strict constraints on the buyer’s management of the company in an effort to ensure that the company met its earnout EBITDA targets. One constraint required the buyer to purchase “60 tractors” per year, and if it did not, the seller would receive the full earnout payment regardless of whether the EBITDA targets were met.

The court determined that the requirement was ambiguous because the parties disputed whether the buyer had to simply purchase 60 tractors, or whether it had to grow its fleet of vehicles by 60 tractors per year. The court admitted extrinsic evidence, most crucially the parties’ negotiating history, and after a four-day trial and consideration of almost 300 exhibits, agreed with the seller’s interpretation and required the buyer to pay a $40 million earnout fee.

Meredith Ervine