‘Earn-outs’ in acquisitions prompting litigation

A legal expert is giving business owners his top tips for avoiding litigation when selling their company.

Andrew Holden, solicitor in the Litigation team at law firm Napthens, explains that as the economy recovers the number of mergers and acquisitions taking place is increasing. However, with cash flow still tight for many businesses, there is potential for litigation post completion.

He points to ‘earn-outs’ or clauses written into some business sales or acquisitions which mean the seller will receive further payments based on the future performance of the business. They are increasingly becoming one of the main causes of disputes after a sale.

For instance, if a seller has not declared all the information they should as a sale is taking place, they may not receive the earn-out payments they are expecting.

Andrew said: “Earn-out is traditionally a good way of ensuring a seller maximises the value of the business for both himself and the purchaser. It ties the seller to the business for a set period of time, ensuring a smooth handover of both ownership and know-how.

“Staying on under a consultancy or management services agreement, the outgoing owner or management team can ensure a profitable transition and maximise the value of the business. This in turn maximises the seller’s earn-out, while handing over a growing and profitable business.

“However, we have dealt with a number of cases in recent years where litigation has resulted following disagreements between the new owners and the seller.

“In practice, in an unpredictable business environment, things don’t always go according to plan. The seller and the purchaser may not agree on the earn-out accounts and calculations because the business is not as profitable as the purchaser had hoped, or because of unforeseen contingent liabilities. This can lead to disputes which are usually resolved through expert determination.

“However, expert determination may itself be unpredictable. It is therefore important for sellers to be open and transparent when a sale is taking place. If they know there is an issue - disclose it, for instance customer complaints or claims relating to a product or service, which might affect future sales. “Working closely with a legal adviser during the process is a must, and can reduce the risk of litigation at a later stage.”