DealLawyers.com Blog

This recent HLS Blog from A&O Shearman does a deep dive on earnouts. Quoting Vice Chancellor Laster’s words, “an earn-out often converts today’s disagreement over price into tomorrow’s litigation over the outcome,” the blog notes that “disputes resulting from earn-out provisions mean that the parties’ negotiations over price are effectively only postponed until after closing.” When more money is allocated to the earnout and the duration is longer, disputes are more likely.  And, in fact, disputes often also arise out of the dispute resolution process itself.

Pointing to a 2023 decision in which the Third Circuit overruled the District Court’s ruling that compelled arbitration, the blog notes that these disputes often center on distinguishing between arbitration and expert determination as outlined in the contract. Here are the blog’s tips for dispute resolution:

Include a dispute resolution mechanism. The agreement should set for the method and venue for handling any disputes. Arbitration tends to be quicker and more cost effective and include greater confidentiality. However, litigation includes availability of appeal and may alleviate concerns over arbitrator competency or compromise judgements.

Clearly define whether the third-party decider is acting as an arbitrator or an expert. Use explicit language such as “acting as an expert, not an arbitrator” to avoid ambiguity.

Limit the authority of the expert to specific factual disputes within their technical expertise. For example, specify that the expert’s role is confined to resolving accounting-related issues relating to the calculation of EBITDA, revenues or other financial milestone as applicable, and not broader disputes as to whether the buyer used the requisite level of efforts to achieve the milestone or complied with the applicable covenants regarding the conduct of business during the earn-out period.

The parties may want to limit what the independent accountant can review to minimize the time and expense of engaging the independent accountant to resolve the dispute. For example, they can limit the independent accountant’s review to: (i) items raised in the objection notice that have not been resolved by the parties and (ii) factual or mathematical errors contained in the information provided to or by the buyer.

The parties may also want to have the independent accountant base its decision only on those materials provided to it by the buyer and seller (rather than conducting its own independent investigation). However, if a party believes that these limitations could be disadvantageous, it should consider being silent on this issue in the agreement and negotiating it when a dispute arises.

Include or exclude procedural rules to signal the intended dispute resolution process. Arbitration provisions should reference formal procedural rules (e.g., AAA rules), while expert determinations should avoid such references and outline a less formal process.

Consider including escalation or mediation provisions, although, generally, not both, as a required preclude to litigation or arbitration, with any escalation or mediation being subject to clear and reasonably short timelines and escalation being to senior executives within each organization who have the authority to quickly resolve a dispute.

– Meredith Ervine