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San Diego Earn Out Provisions: Tips on Avoiding Post-Acquisition Litigation

When a small-to-medium sized San Diego business is acquired by another business, often the new owners want to retain the previous owners in an employment capacity. This can be beneficial to both sides of the bargain. The new owners obtain continuity, relevant skills, and specific market expertise; the previous owners obtain the ability to continue building their business, continue to have employment/source of income and, generally, obtain additional payments through a negotiated earn-out provision. Earn-out provisions set targets for business maintenance and growth. Further payouts to the previous owners are linked to meeting those targets.

These types of provisions are important for the new owners since there is an inherent risk and uncertainty when acquiring any business. Sure, the financials and sales reports may document certain revenues and expenses, but company books can be manipulated, customers may be leery of the new management, and market conditions are constantly changing. Without an earn-out provision, the purchase price is likely to be substantially lower. This is why earn out provisions are common when the previous ownership/management is retained.

That being said, earn-out provisions are also a common source of litigation. Thus, it is important to structure the earn-out properly by retaining an experienced San Diego corporate attorney. With respect to the earn-out provision, here are three tips that can help avoid litigation.

First, the earn-out formula should be based on revenues/sales, should be clear, and should never be “all-or-nothing.” Basing the earn-out formula on revenues/sales — rather than on earnings or profits — can help reduce the risks of litigation because there are typically fewer arguments about what constitutes “revenue” or “sales.” Generally speaking, there is only one component of “revenue” or “sales.” By contrast, with “earnings” or “profits,” there are at least two components — revenue and costs. As such, if the earn-out formula is based on “revenue” or “sales,” logically, there are at least half as many potential issues to dispute. Further, defining “cost” can be quite complicated. Indeed, without question, there can be legitimate business disputes about what constitutes a “cost” and how that “cost” should be determined and allocated. Furthermore, the earn-out formula should be simple — something like “1% of sales” with “sales” being clearly defined to include/exclude various foreseeable products, contracts, services, etc. Finally, an earn-out should never be “all-or-nothing.” The most common circumstance where litigation is filed occurs when the earn-out formula results in no additional payout to the previous owner(s). The previous owners have nothing to lose and everything to gain by filing litigation. A sliding-scale formula is always better since the previous owners are, in theory, happy to receive some additional payment. Moreover, the acceptance of a payment or payments is useful evidence if there is litigation.

Second, the time intervals for the earn-out should be short and linked to the terms of employment. Often, parties simply “default” to a one-year length of time, but shorter time intervals should be considered. For example, quarterly sales/revenue goals (and payouts) could be advantageous since all parties involved will quickly discover whether the targets are reasonable, whether they are achievable, whether other factors need to be considered, etc. The term of employment for the previous owners should track the same intervals along with clear statements stating that continued employment is contingent on meeting the targets.

Third, the parties should agree in advance to a binding method of dispute resolution that avoids costly and time-consuming litigation. The options include some combination of:

  • Mandatory arbitration
  • Binding mediation and
  • Expert determination

Agreement should also be had in advance on how to allocate the costs of the agreed-upon dispute resolution mechanism.

Call San Diego Corporate Law Today

For more information, call attorney Michael Leonard, Esq., of San Diego Corporate Law. Mr. Leonard provides legal services related to business law, private securities offerings/sales, the sale/purchase of a business, and for mergers and acquisitions. Mr. Leonard can also assist with setting up a new corporate entity, annual corporate maintenance, and can help review and draft business contracts. Mr. Leonard can be reached at (858) 483-9200 or via email. Like us on Facebook.

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