Validity of Earn-Out Notice: Form Can Be Just As Important As Substance.

In a recent case, the Court of Appeal made clear that a failure to follow wording set out in a share purchase agreement when calculating earn-out consideration can render the earn-out notice invalid. 

What is an earn-out?

An earn-out is a mechanism often used in corporate acquisitions whereby all or part of the purchase price is based on the post-completion performance of the target company acquired (the “target company”).  Typically earn-outs are linked to the financial performance of the company over a certain period of time, and can be based on criteria such as the sales turnover, net assets or a combination of both.

What are the facts of the case?

Treatt plc v Barratt and others [2015] EWCA Civ 116, concerned the sale by Barratt (B) of the entire issued share capital in two companies to Treatt (T) pursuant to a share purchase agreement.  The purchase price payable by T for the shares was structured as an earn-out.  The earn-out consideration was calculated by reference to the aggregate pre-tax profit or loss of the target companies and their subsidiaries as shown in the audited accounts of the target companies over a defined two year period.  The buyer was required to provide notice of the earn-out consideration to the seller following completion.

The share purchase agreement set out the mechanism for calculating the earn-out, the financial information that the earn-out should be based on; the way in which the buyer should send the earn-out notice to the seller, and the timeframe in which it was required to do so. 

Shortly after completion, the buyer changed the accounting period of the target companies.  This meant that the earn-out specified in the earn-out notice issued by the buyer was not based on the profits made during the financial periods that had been specified in the share purchase agreement, but on accounts for a different period. 

The seller challenged the earn-out notice as being invalid because of this, and both the High Court and Court of Appeal agreed.

The Court of Appeal stated that the earn-out calculation provided for in the share purchase agreement was a “contractual protection of real importance”, and was not a “mere formality”.  Further, they stated that the error in question could not be compared to an accidental mathematical error in calculation.   This, the court made clear, would not have invalidated the notice – but failure to follow the proper contractually defined earn-out formula did.   The court considered the earn-out notice to be “wholly non-compliant” with the contractual obligations contained in the share purchase agreement, and as such the notice was invalid.  The effect of this meant that the earn-out had to be referred to an independent arbitrator to be determined. 

Comment.

Earn-outs are frequently used in corporate acquisitions, and as such, this case acts as a useful reminder of the following things:

• The courts will take a strict approach to construing earn-out notices, and will not allow a departure from clear contractual requirements – even when these are made in good faith;

• Parties should also ensure that the terms of their earn-out provisions are clearly set out in the contract underpinning the transaction; they should make sure that the calculations have been fully worked out, including worked examples within the agreement if need be;

• Importantly, parties should ensure that the mechanisms for serving earn-out notices are feasible -  ensuring that the requirements are practical and can be easily and realistically achieved; and

• Parties should make sure the earn-out provisions (and any other relevant post-completion provisions) are brought to the relevant adviser’s attention, especially if the solicitor involved in drafting of the agreement has little or no involvement with the company post-completion.  Failure to adhere to the strict rules, as we have seen, can be costly and produce undesirable results.

If you would like advice on earn-out provisions, or anything contained in this article, contact me on 0131 625 9191 or via email: lisa.kitson@davidsonchalmers.com. 

Disclaimer 
The matter in this publication is based on our current understanding of the law.  The information provides only an overview of the law in force at the date hereof and has been produced for general information purposes only. Professional advice should always be sought before taking any action in reliance of the information. Accordingly, Davidson Chalmers LLP does not take any responsibility for losses incurred by any person through acting or failing to act on the basis of anything contained in this publication.