Last year someone—I’ll call him George—hired me to analyze for him a sentence in a contract.
George had sold his business. Part of the purchase price was to be paid in an earnout: after the closing of the sale, the buyer was to make up to three additional payments to George if in the three years after the closing of the transaction specified revenue targets were met. Revenues at the 12 Month Revenue Measurement Point (as defined in the contract) were determined to be 400 Spondulix (I don’t want to use actual amounts), and the buyer paid George the first Annual Earnout Payment. The buyer then told George that revenues in the second year of the three-year period were likely be approximately 100 Spondulix. George and the buyer got into a dispute over the second earnout payment.
Here’s the language at issue:
The second Annual Earnout Payment (if any) shall be based upon and thus calculated on the Revenues as of the 24 Month Revenue Measurement Point to the extent the Revenues measured at the 24 Month Revenue Measurement Point are greater than the Revenues at the 12 Month Revenue Measurement Point.
What gave rise to the fight? (Take your time.)
The buyer’s position was that “the Revenues as of the 24 Month Revenue Measurement Point” meant the second year of revenues. George’s position was that it meant the first two years of revenues. I wrote George five-page letter explaining why the wording of the contract strongly favored his interpretation.
I’m writing about this not because this dispute is somehow more compelling than any number of others. Instead, it’s simply that I spend so much of my time writing about specific words and phrases, and specific causes of uncertainty, that it’s a good idea to remind myself regularly that the causes of contract disputes are as disparate as the nature of those disputes.
In this case, the culprit wasn’t one of the usual suspects, for example a confusing phrase such as indemnify and hold harmless. Instead, the drafter referred to a point in time when they should have referred to a period of time.
So disputes can arise in innumerable ways. Let’s be careful out there.
(Oh, and George ended up settling. Whatever the merits of one’s position in a contract dispute, the person holding the money has an advantage.)
Time periods seem to trip people up in contracts. For an English case that shows this type of muddle, see Cambridge Display Technology v E I Dupont de Nemours [2005] EWCA Civ 224 (CA).
Hard thinking, followed by very careful drafting, is required to avoid the ambiguity in these examples. It is an undervalued skill-set!
Dear Mark,
You say: ‘Time periods seem to trip people up in contracts.’
Truer words were never spoken, but the example in this blog post is surely an unusual one.
The commoner problem is the failure to describe the start and end points of periods precisely, giving rise to a lot of baggage about ‘inclusive’ and ‘exclusive’ or other wordy alternatives to describing two-ended periods from point to point.
One of the skills in the set you refer to is simply realizing that time period descriptions like the following use periods instead of points as their ‘bookends’ and need fixing:
‘The term of the lease is from August 14, 2020 to September 15, 2020.’ (Dates are periods, not points.)
‘The Manager shall keep the Resort open each year from June to September.’ (Months are periods, not points.)
The fix is easy once one learns to see the problem:
if period descriptions are few, elaborate a bit on site (eg, ‘from midnight at the start of August 14, 2020 to midnight at the end of September 15, 2020’).
If period descriptions are many, use what Ken now calls ‘an internal rule of interpretation’ to enable concise but clear time references on site.
I don’t mean to imply that you’re an offender — doubtless the opposite is true. It’s just that your observation about time periods tripping drafters up pushed one of my hobby-horse buttons and the fingers began to type.
With best regards,
Wright
Ken:
Huh. Thirty-second take: I’d have said the amount was to be calculated as (revenues from day 1 to 24-month point) – (revenues from day 1 to 12-month point). The reason is that it is supposed to be calculated based on Revenues as of the 24-month point “to the extent [they] are greater than” Revenues as of the 12-month point. That says subtraction to me. If it had said “if [they] are greater than,” then I would have agreed with your reading.
What was the definition of Revenues?
Chris
I think you may be right as to what the language actually means from a legal interpretation standpoint, but it would be a dumb way to provide an earnout reward. Basically, as interpreted, so long as the business earned any revenue in year 2, the seller gets an earnout payment because what wa searned in the prior 24 months will always exceed what was earned in the first year. It’s just a way for the seller to share in all revenue generated by the business after closing during the earnout period. Maybe that was “the deal” as intended by the parties but that doesn’t seem like a likely way to structure an earnout — it’s really terrible for the buyer. I would imagine what was intended by the buyer was rewarding revenue growth — if if the business earned 400 in year 1, it would have to earn >400 in year 2 in order to trigger a payment.
Looking at this a bit forensically and a bit speculatively, based on what has been posted what seems clear is that the person who drafted this did not understand a basic accounting principle that revenues are only measured over a time period, not as of a specific date. Maybe in a casual negotiation conversation people used colloquial statements like “yeah, and if revenues at 24 months are more than at 12 months, then the second payment gets triggered”, and the lawyer more or less transcribed that conversation.
Anyway, interesting stuff and a reminder of why business lawyers really need to understand accounting.
Agreed, though an alternative to understanding accounting, engineering, nuclear physics, molecular biology or any other discipline that comes up in contracts, is to ask dumb questions and keep asking them until you are absolutely certain what the deal term is. Transactional IP lawyers have to do this all the time.
Eddie:
I’m assuming that either (a) the definition of “Revenues” does something or (b) the real deal was some kind of percent commission on revenues for some period of time or (c) there is a formula that Ken hasn’t provided. This sentence just says what the earnout is based on, not how it is calculated. The calculation could say something like, if the relevant Revenues as defined above are less than $1m, the earnout is zero.
I tend to concur with your speculative diagnosis of the cause.
Chris
The definition of Revenues does nada (see my response to your earlier comment) and there ain’t no hidden formula.
The interpretation that my client argued for, and that was supported by the wording of the contract, might be dumb, but the interpretation sought by the other party was if anything dumber: if the business earned 400 in year 1 and 401 in year 2, my client would get an earnout payment based on 401 minus 400.
Use of “to the extent” was one of the reasons why I reached the conclusion I did.
“Revenues” was defined to mean simply
“gross revenues generated and received by the Company from goods and services
provided by the Company.”
Do you have a blog post on why “Indemnify and hold harmless” is confusing? I have this in every agreement, and I see it in almost every agreement, so although I understand why other phrases are archaic and should be edited out of agreements, what is the confusion here? Please don’t be upset for changing the thread, but I would like to have more info on this phrase.
No problemo. Just click on the “Categories” button on this blog (to the right), select “Indemnification,” and you’ll find beaucoup posts on indemnification, including some on “hold harmless.” But the definitive discussion is in MSCD.
Thank you. I appreciate it. I have the MSCD, and I am slowly making way through it.