Legal Remedies for Earnout Breaches in M&A

Earnouts in M&A deals tie part of the purchase price to future business performance, but disputes are common. Misaligned expectations, vague contract terms, and operational conflicts often lead to breaches. Legal remedies include:

• Specific Performance: Forces the breaching party to fulfill obligations.
• Compensatory Damages: Covers financial losses from missed payments.
• Liquidated Damages: Predetermined compensation for breaches.
• Rescission: Cancels the contract entirely.
• Contract Termination: Ends future obligations without undoing the deal.

Clear contract drafting is critical to avoid disputes. Define performance metrics, calculation methods, and operational responsibilities upfront. For disputes, alternatives like arbitration or mediation can save time and costs compared to litigation. Proactive planning and detailed agreements are key to managing earnouts effectively.

Contract Law Remedies for Breach: Equitable Remedies

Main Legal Remedies for Earnout Breaches

When an earnout agreement is breached, the party that suffers the harm has several legal avenues to consider. As previously mentioned, precise and well-drafted contracts are key to enforcing these remedies. The choice of remedy largely depends on the specific breach, the contract's wording, and the outcome the injured party hopes to achieve. Each remedy offers a different path forward, tailored to the nature of the breach and the goals of the aggrieved party.

Specific Performance

Specific performance compels the breaching party to fulfill their obligations under the agreement, rather than simply paying damages. This remedy is particularly effective when the buyer's actions directly hinder the seller's ability to meet earnout targets. For example, if a buyer fails to provide the necessary resources for the seller to achieve performance goals, a court may order the buyer to take corrective measures.

That said, specific performance often requires continued court involvement, which can be time-consuming and costly. Courts are also less likely to enforce this remedy if the contract's terms are too ambiguous or if ongoing oversight would be impractical. Compared to monetary compensation, this option is more complex and is generally reserved for situations where financial damages alone would not suffice.

Damages: Compensatory and Liquidated

Compensatory damages aim to place the injured party in the financial position they would have been in if the breach had not occurred. This usually involves calculating the missed earnout payments based on what the agreement outlined. Proving these damages often requires expert analysis and a detailed review of financial records.

Liquidated damages, on the other hand, are predetermined amounts specified in the contract to be paid in the event of a breach. This approach allows the injured party to recover losses without the need to prove the exact financial impact. However, for liquidated damages to be enforceable, they must represent a reasonable estimate of potential harm at the time the contract was signed. If the amount is deemed excessive or punitive, a court might rule it unenforceable.

Rescission and Contract Termination

Rescission cancels the contract entirely, aiming to restore both parties to their original positions before the deal. This remedy is typically used when a breach undermines the entire purpose of the agreement. For instance, if a buyer disrupts the acquired business to such an extent that achieving the earnout becomes impossible, rescission could be a viable solution.

Contract termination, in contrast, ends any future obligations between the parties without attempting to undo actions already taken. This option is often more practical when continuing the agreement is no longer feasible or when a breach makes further collaboration pointless.

Courts carefully assess the severity of the breach and the logistical challenges of undoing a deal. Rescission is generally reserved for the most severe breaches, while termination is considered a more workable option for less extreme scenarios. As emphasized earlier, having clear and detailed contract terms can make these remedies more straightforward to enforce.

How to Enforce Earnout Agreements

After identifying a breach and deciding on a remedy, enforcing an earnout agreement often involves litigation, alternative dispute resolution (ADR), or interim measures.

Litigation in Earnout Disputes

Litigation is the most formal - and often the costliest - path to resolving earnout disputes. It typically begins with filing a complaint, followed by an extensive discovery process. This phase may include document reviews, depositions, and expert financial analysis. Ultimately, the case goes to trial, where a judge or jury decides whether a breach occurred. While litigation can be resource-intensive and time-consuming, it’s sometimes the only viable option, especially in cases involving serious fraud or major contract violations.

"An earn-out…typically reflects disagreement over the value of the business that is bridged when the seller trades the certainty of less cash at closing for the prospect of more cash over time…But since value is frequently debatable and the causes of underperformance equally so, an earn-out often converts today's disagreement over price into tomorrow's litigation over the outcome."
– Vice Chancellor Laster, Delaware Chancery Court

Arbitration and Mediation

ADR methods, like mediation and arbitration, are frequently used to resolve earnout disputes in M&A agreements. Mediation involves a neutral third party who helps both sides find a mutually acceptable solution. This less formal process promotes open communication and allows for creative compromises. It’s often a cost-effective starting point, especially since post-closing disputes arise in 56% of M&A transactions, and litigation can consume over 50% of escrow funds.

Arbitration, on the other hand, is more structured than mediation but still occurs outside the court system. It’s often included in earnout agreements as a way to resolve disputes more quickly and privately than litigation. Arbitration rulings are usually binding, with limited opportunities for appeal. Many agreements use a tiered approach to dispute resolution: starting with a written notice of the issue, followed by a mandatory negotiation period (often 30 days), then mediation, and finally, binding arbitration if no resolution is reached.

Seeking Interim Relief

During the resolution process, interim relief might be necessary to protect your earnout rights and prevent further harm. For example, you could seek to halt actions like selling key assets or firing essential personnel that could jeopardize earnout targets.

To secure interim relief, you’ll need to demonstrate that immediate action is critical to prevent irreparable harm - harm that monetary compensation alone wouldn’t address. In some cases, courts may also freeze assets to ensure funds are available for earnout payments. Because these situations often require urgent attention, acting swiftly is essential to safeguard your legal standing.

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Preventing Disputes in Earnout Agreement Drafting

Avoiding disputes in earnout agreements starts with precise drafting. A well-crafted agreement with clear provisions can eliminate many potential conflicts before they even surface. By addressing ambiguities upfront, parties can sidestep the need for complex remedies later. As Vice Chancellor J. Travis Laster of the Delaware Court of Chancery aptly stated, "an earn-out often converts today's disagreement over price into tomorrow's litigation over the outcome". The following drafting strategies aim to minimize conflicts and ensure smoother execution.

Contract Provisions to Minimize Ambiguity

Use clear, measurable performance metrics. Avoid vague terms like "substantial revenue growth." Instead, define specific targets, such as achieving a yearly revenue threshold or hitting a particular EBITDA margin. These measurable goals leave little room for interpretation and make it easier to evaluate success.

Detail calculation methods, including adjustments for unique circumstances. Be explicit about how earnout payments will be calculated. For example, clarify whether revenue calculations should account for returns, allowances, or international currency fluctuations. Specify acceptable deductions from gross revenue to avoid future disputes.

Outline operational responsibilities for both parties. Replace ambiguous terms like "reasonable efforts" with concrete requirements. For instance, specify actions such as maintaining minimum staffing levels, continuing existing marketing plans, or preserving key customer relationships. These details ensure both buyer and seller understand their obligations.

Establish clear timelines for dispute resolution. Define deadlines for submitting written dispute notices and set a fixed negotiation period before arbitration. Clearly outline which disputes will go to expert determination and which require formal arbitration, specifying the qualifications needed for any involved expert.

Including Liquidated Damages Clauses

To further reduce litigation risks, consider adding liquidated damages provisions. These clauses outline predetermined compensation for specific breaches, such as failing to meet agreed staffing levels or discontinuing essential product lines. Liquidated damages should represent a reasonable estimate of losses, not a penalty. For example, if the buyer must maintain a minimum marketing budget, the liquidated damages could cover both direct losses and related opportunity costs. By setting fixed remedies, these provisions simplify dispute resolution and eliminate the need to prove actual damages.

Monitoring and Audit Rights for Compliance

Require regular reporting and record retention. The agreement should mandate detailed financial and operational reporting - monthly or quarterly - along with updates on progress toward earnout goals. Specify the format and supporting documentation required, such as customer contracts or expense receipts. Additionally, outline record retention policies, including duration and format.

Grant comprehensive audit rights. Sellers should have the ability to verify compliance through audits that go beyond standard financial records. These rights should include access to operational data, customer information, and strategic documents. Clearly define audit frequency and cost-sharing arrangements to avoid misunderstandings.

Establish regular communication protocols. Ongoing alignment between buyer and seller is crucial during the earnout period. The contract should require periodic meetings to review performance, address challenges, and resolve concerns early. These sessions should involve key stakeholders and follow a structured agenda covering financial results, operational metrics, and market conditions.

Investing in detailed and precise drafting can save both parties from the financial and emotional toll of earnout litigation. When expectations, measurement methods, and dispute resolution processes are clearly laid out, everyone can stay focused on achieving their shared business goals instead of preparing for courtroom battles.

Comparison of Legal Remedies for Earnout Breaches

When disputes over earnouts arise, there are several legal remedies to consider, each with its own strengths and challenges. Understanding these options can help M&A professionals make informed decisions that align with their specific needs and priorities. This section builds on earlier discussions about enforcement strategies by examining when and why each remedy might be the best fit.

Choosing between litigation, arbitration, and mediation often hinges on factors like enforceability, costs, speed, convenience, and the need for specialized knowledge. Legal experts suggest weighing these considerations carefully to determine the most effective path forward.

Pros and Cons of Different Remedies

Here’s a comparison of the main remedies, highlighting their advantages, drawbacks, and ideal use cases:

Remedy Type	Advantages	Disadvantages	Best Used When
Specific Performance	Ensures compliance and preserves the deal structure.	Challenging to enforce, requires court oversight, and can strain business relationships.	When unique obligations are involved, or the buyer’s actions threaten earnout targets.
Compensatory Damages	Covers actual financial losses and provides flexibility.	Requires proving damages and may not account for all losses; collecting damages can be difficult.	When financial harm is clear, and losses are quantifiable.
Liquidated Damages	Predefined amounts simplify resolution and avoid debates over calculations.	Must reflect a reasonable estimate of loss and may not perfectly match the actual harm.	When breaches are anticipated, and certainty over liabilities is preferred.
Rescission	Reverses the transaction, restoring parties to their original positions.	Disruptive, impractical after integration, and limited to fundamental breaches.	In cases of material misrepresentation or early, significant breaches during the earnout period.
Litigation	Offers comprehensive remedies, broad discovery rights, and potential public precedent.	Expensive, time-consuming, unpredictable, and involves public proceedings.	For complex disputes requiring discovery or when setting precedent is important.
Arbitration	Provides private, binding resolutions with industry expertise, often faster than litigation.	Limited appeal options, challenges in arbitrator selection, and potentially high costs.	For technical disputes where privacy and a final, binding outcome are priorities.
Mediation	Encourages cooperative negotiation, preserves relationships, and is cost-effective.	Non-binding and reliant on mutual cooperation; may not resolve all issues.	When maintaining relationships is important, and a flexible, collaborative approach is preferred.

Arbitration stands out as a strong alternative to litigation in many earnout disputes. Under the Federal Arbitration Act, arbitration awards are given significant deference, ensuring finality and reducing uncertainty. This makes arbitration particularly appealing in cases where privacy and a definitive resolution are key.

Proactive measures can make a difference. Engaging a damages expert early can clarify potential losses and set the stage for mediation, which often preserves relationships and allows for creative solutions. Additionally, third-party funding can help manage legal expenses, as fees are typically contingent on financial recovery. These strategies can improve outcomes and guide M&A professionals in tailoring their approach to each unique dispute.

Combining different remedies can also be highly effective. For instance, starting with mediation to maintain relationships, moving to arbitration for a binding decision, and resorting to litigation for enforcement can provide a balanced approach. Accurate cost forecasting and budgeting are also critical to avoid financial surprises and make well-informed decisions.

Finally, well-crafted dispute resolution clauses in M&A agreements are essential. These clauses can specify the appropriate remedies for various scenarios, reducing both the time and expense involved in resolving earnout disputes.

Conclusion and Main Takeaways

Summary of Best Practices and Remedies

Earnout provisions appeared in 37% of M&A deals in 2023, and U.S. earnout lawsuits nearly doubled between Q1 2022 and Q1 2023. These numbers highlight the growing importance of implementing effective strategies to prevent and address disputes.

"An earn-out often converts today's disagreement over price into tomorrow's litigation over the outcome" - Vice Chancellor J. Travis Laster

The key to avoiding these conflicts lies in combining well-drafted contracts with thoughtful remedies. When creating earnout agreements, prioritize clear and measurable performance criteria, transparent reporting processes, and comprehensive dispute resolution clauses.

Selecting the right remedies is equally important. Use compensatory damages to address financial losses and specific performance for obligations that can't be replaced. Arbitration, with its privacy and finality, is becoming a preferred alternative to public litigation.

Recent trends, particularly in Delaware courts, show rulings often favoring sellers over buyers. This shift underscores the importance of detailed documentation and clear operational guidelines during the earnout period.

Final Advice for M&A Professionals

To navigate earnouts successfully, M&A professionals should take proactive steps to manage potential disputes. Keep detailed post-acquisition records, documenting decisions and their reasoning. Such records can be critical if disagreements arise, as misinterpretation of earnout clauses often leads to lengthy and expensive litigation.

When appropriate, consider alternatives to traditional earnouts. For instance, performance-based employee compensation or bonuses can sometimes achieve similar goals while minimizing the risk of disputes. If earnouts remain the best choice, ensure all transaction documents consistently outline how payments will be calculated.

Act quickly at the first sign of conflict. With Delaware Court of Chancery earnout disputes quadrupling in Q1 2023, early intervention can prevent escalation.

Additionally, leveraging tools like Kumo can streamline deal sourcing. Kumo's AI-powered features and custom search filters help identify potential opportunities efficiently, freeing up time to focus on structuring strong earnout agreements.

Lastly, align earnout terms with employment agreements when recipients are part of the management team. This alignment reduces conflicts of interest and creates incentives that support both earnout goals and broader business success.

Managing earnouts effectively requires preparation, clarity, and strategic decision-making. With their growing use in M&A deals, mastering these skills is becoming essential for achieving successful outcomes.

FAQs

What challenges might arise when enforcing specific performance for earnout breaches in M&A deals?

Enforcing specific performance in cases of earnout breaches tends to be tricky, largely because courts are reluctant to mandate actions that involve subjective judgment or managerial discretion. Take obligations like "best efforts" or "commercially reasonable efforts" as an example - these are inherently hard to define and evaluate, which often sparks disagreements about whether the required standards have been met.

On top of that, courts usually lean toward awarding monetary damages rather than enforcing specific actions. Financial compensation is often viewed as a more practical and fair solution in such disputes. These challenges make specific performance a less reliable option when resolving earnout disagreements.

What steps can parties take to make liquidated damages clauses in earnout agreements enforceable?

To make liquidated damages clauses in earnout agreements enforceable, it's crucial to focus on two main aspects:

• Reasonable Estimate of Harm: The amount specified in the clause should represent a fair and reasonable prediction of potential damages at the time the agreement is signed. If the amount is excessive or appears punitive, courts may interpret it as a penalty and refuse to enforce it.
• Uncertainty of Damages: These clauses work best when the actual damages from a breach are hard to determine or calculate. If the harm can be easily measured, courts may require proof of damages instead of allowing reliance on a pre-set figure.

By addressing these points during the drafting process, parties can strengthen the enforceability of these clauses and minimize the likelihood of disputes when carrying out earnout agreements.

What steps can M&A professionals take to minimize the risk of earnout disputes when drafting agreements?

To reduce the chances of earnout disputes, M&A professionals should focus on crafting agreements with clear, detailed terms. This means spelling out performance metrics, timelines, and payment calculations in a way that leaves no room for misinterpretation. When agreements rely on specific and measurable criteria for earnout triggers and outcomes, everyone involved can operate with a shared understanding of what’s expected.

Another key step is including dispute resolution mechanisms, like arbitration or mediation clauses, in the agreement. These provisions can simplify the process of resolving conflicts and help avoid expensive legal battles. By addressing potential disagreements upfront, professionals can build agreements that are both practical and enforceable.

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