Article on Clumsy Drafting of an Earnout Provision

A common feature of M&A contracts is the “earnout” provision—a provision that specifies that the purchase price will be increased if the business being acquired meets, post-closing, stated financial-performance targets.

If you’re interested in earnout provisions, of if you’d just like to see yet one more example of how lackadaisical drafting can result in litigation, you might want to check out a recent New York Law Journal article entitled “Negotiating Earnout Provisions in Acquisition Pacts.” It’s by Christopher Lamal of the New York City-based Lamal Law Office. Click here to go to a copy.

About the author

Ken Adams is the leading authority on how to say clearly whatever you want to say in a contract. He’s author of A Manual of Style for Contract Drafting, and he offers online and in-person training around the world. He’s also chief content officer of LegalSifter, Inc., a company that combines artificial intelligence and expertise to assist with review of contracts.

4 thoughts on “Article on Clumsy Drafting of an Earnout Provision”

  1. The article’s main thrust, that careless drafting costs money, is as true as ever. I perhaps have more sympathy for the court’s view that “outside audited financial information” would include more than simply the gross revenue, given that there was a requirement for “commercially reasonable efforts” to be used – how else could such a requirement be assessed? Given the ambiguity, that is a pertinent question. I therefore think the cost of the poor drafting here was probably not that the decision went the wrong way, but that it had to be put through the courts at all.

    As an aside, I’m also slightly doubtful about the idea that there was no obligation to provide the accounts. I agree that it was not expressed as such, but the court can and should look beyond how an obligation is dressed up when considering whether it is a penalty clause. In this case the seller wanted audited accounts delivered, and the buyer was to pay the full amount if he didn’t deliver it. It shouldn’t matter how you express it.

  2. Hi Art,

    I don’t think the case was wrongly decided. To my mind, it was decided the only way the court could reasonably have decided it. I do think, however, that the judge paid too much attention to the testimony of one of seller’s directors that one the purposes of the provision at issue was to permit seller to confirm whether the buyer had used “commercially reasonable” efforts. But that was irrelevant to the outcome of the case, because the court decided on completely other grounds.

    Your comments on the ambiguity of the phrase “financial information” seem to me to restate the problem that not even the court ventured to resolve: of figuring out just what kind of information the buyer was expected to provide.

    If the agreement had referred to “financial statements” (instead of “financial information”), then one could easily argue that what was supposed to be provided was a set of statements consisting of a balance sheet and income and cash flow statements and the related notes. That’s what the phrase “financial statements” is generally understood to mean in corporate practice in the absence of any limiting context. By using instead, however, the phrase “financial information” without explanation, the parties left open the question of just what kind of additional information beyond gross sale figures buyer was expected to provide.

    As I noted in the article, even just an income statement would have provided both too little and too much information to be useful, especially where (as here) the acquired business was going to be integrated into the buyer’s existing business and not operated as a stand-alone entity for financial reporting purposes.

    From the seller’s perspective in particular, it would have provided too little information, because it would not indicate how much the buyer spent on marketing the acquired business as opposed to its existing business, nor would it indicate the quality of the marketing effort.

    Speaking from my own experience, if a seller is really concerned about setting some contractual standard on whether the buyer has used “commercially reasonable” efforts, it will insist on specific covenants concerning, for example, the amount of marketing budget specifically devoted to the acquired line of business and the continued use of seller’s existing sales team and distribution network. It won’t just refer to some vague concept of “financial information.”

    As to whether there was a contractual obligation in the first place for buyer to provide financial information beyond gross sales figures: As you have confirmed, there is no such obligation expressly set forth in the agreement. I can only speculate why that was the case (and offered a speculation of my own in the article). My point is that each side may have had strategic reasons for not formulating this as a contractual obligation.

    I would be very leery of courts’ trying to impose, as a matter of contract, obligations on parties that they had not expressly agreed to within “the four corners” of the document.

    The irony here, of course, as I discussed in my article, is that if the court really had read into the agreement a contractual obligation by buyer to provide whatever financial statements it was supposedly obligated to provide, then buyer would have presumably been in the enviable position of arguing to the court: “Even assuming, your Honor, we breached the agreement by not providing the kind of “financial information” seller claims we should have provided, seller suffered no actual damage because as we can now show, the financial results of the business were so poor that that the seller would never have been entitled to an earnout payment anyway!”

    I think it best that the court did not read into the contract an obligation that was not specifically expressed. Had it done so, it would have simply condoned sloppy and careless drafting.

    Thanks for the opportunity to clarify my article.


  3. I don’t agree with Art Markham that: “[T]he court can and should look beyond how an obligation is dressed up when considering whether it is a penalty clause. In this case the seller wanted audited accounts delivered, and the buyer was to pay the full amount if he didn’t deliver it. It shouldn’t matter how you express it.”

    I think it does matter how you express it.

    One can draft a contract with alternative performances without the alternative performance being a penalty. For example, a cancellation fee for the privilege of shortening the term of a lease or service contract is not ordinarily a penalty. If one elects not to shorten the term but is still liable for the cancellation fee, then I agree that it can be a penalty. But careful drafting allowing the alternative of paying the cancellation fee or being liable for actual damages for breaching before the expiration of the original term should avoid the penalty issue.

    Furthermore, in this case it makes sense to read the clause as a condition rather than a covenant. If the buyer didn’t want to open the kimono by providing financial information, the buyer was in effect waiving the condition to the buyer’s obligation to perform. This is particularly true here where the introductory word to the phrase in question is “if.” The same would apply to the preceding phrase [“if (1) Buyer fails to use Commercially Reasonable Efforts to sell products or services derived from Seller’s Intellectual Property,”]. The buyer might decide not to use Commercially Reasonable Efforts (which might cost more than they were worth) and thus to forgo being able to avoid the earnout on that ground. I don’t see the earnout payment as being a penalty for failure to provide financial information.

    Interestingly, the phrase in question in the case was subject to two “ifs.” Before the numbered subclauses started, the agreement contained an “if” and subclause 2 also contained an “if” so that it reads: “if (1) … (2) if outside audited financial information is not provided at the end of the Measuring Period (3) ….” Neither (1) nor (3) contained an “if.” While an argument could be constructed that this shows just how conditional no. 2 was, I suspect it’s just sloppy drafting induced by time pressure.

  4. I was able to view the agreement that was the subject of the article because the author helpfully provided a footnote link to it. It’s ironic that an agreement that was the subject of litigation because of flawed drafting is being offered as a sample agreement (not by the author but by OneCLE). Things that are free are worth twice the price!

    I find the clause in question ambiguous on its face in that it doesn’t identify who is to provide the financial information. While references to providing financial information would normally imply that the party in possession is the one to provide it, here the drafting created an ambiguity. The clause says in part:

    “if (1) Buyer fails to use Commercially Reasonable Efforts to sell products or services derived from Seller’s Intellectual Property, (2) if outside audited financial information is not provided at the end of the Measuring Period, (3) or Buyer terminates more than one of the Transferred Employees”

    Subclause (1) and (3) identify Buyer as the actor but subclause (2) switches to the passive voice and is silent as to the actor. (Yecch!) If nothing else, the conflict between the normal implication of providing financial information and “expressio unius est exclusio alterius” justifies the admission of parol evidence.

    The court’s consideration of the director’s affidavit as to what the clause was “designed” to do is troublesome, however. At least in California, a party’s undisclosed intent as to the meaning of a contract is irrelevant and inadmissible. Courts are interested in what one party said to the other party in negotiations, but they generally refuse to consider “Here is what I thought the contract meant.”

    I also question the court’s adoption of the rule that the agreement should be construed against the buyer. That rule, which is simply an aid to construction when there isn’t other evidence of meaning, really doesn’t apply to a heavily negotiated agreement. If the buyer put forth the agreement and the seller signed it with no changes, then yes, it would be appropriate, but this 52-page agreement doesn’t look like such an agreement. I find it hard to believe that the buyer unilaterally put forth an agreement that called for it to make the full earn-out payment if the specified conditions weren’t met. It seems obvious to me that this clause in particular was the subject of negotiations, and if so, the rule of construing an agreement contra proferentem should not apply. If one side acts as the scrivener for a clause proposed by the other side, the other side might really be the drafter for the purposes of the rule of contra proferentem. And in acquisitions, the buyer often takes control of changes and thus acts as scrivener.

    As to why the seller did not object to the vagueness of “outside audited financial information,” one good bet is that seller’s counsel thought that it would allow the seller to argue it meant something more than whatever the buyer ultimately provided.

    While the decision has a lot of warts, I don’t come away feeling that the buyer got screwed. The fact is that the buyer didn’t provide audited financial information of any kind, even of gross sales, and if it had financial information that would show that the earn-out targets weren’t met, it would have provided the information, at least at trial. So it may have been the right result even though how the court got there may not have been a model to emulate.


Leave a Comment

This site uses Akismet to reduce spam. Learn how your comment data is processed.