Earn-outs (updated from 2012)

I first wrote about earn-outs in 2012 – and the use of an earn-out to bridge the gap between the parties’ value expectations (and risks) in a business sale.

At its simplest, an earn-out is a mechanism whereby the seller is paid an additional amount (over and above a base price for the business) based on its actual future performance.  Whilst there are a variety of shapes and sizes of earn-out, depending on the nature of the business and the pattern of the negotiations between seller and buyer.  An earn-out is more common where there will be a period of assistance by the seller after the business has been sold.  In the typical SME example, the owners will have built the business that they have also managed and a key part of the earn-out is often that they are retained for a period after the sale to continue in a management capacity.

An earn-out is typically linked to a measure of post-sale profitability (typically EBIT – Earnings Before Interest and Tax).  It is also often said that earn-outs will be used where the value of the business is only partly attributable to the physical assets.  As such it can be said to act as a sort of dividend on the business achieving some or all of the goodwill component of the valuation.

Back in 2012, I wrote about the benefits (for vendor and purchaser of an earn-out) but also mentioned the pitfalls.  Two High Court decisions this year flesh out those pitfalls.

Two (actually three) recent High Court decisions involving acceleration mechanisms linked to an earn-out (one holding that liability to pay the earn-out had not been triggered – and the other finding that the acceleration mechanism did apply) underline the risks issues that need to be considered when negotiating and drafting earn-outs.  In keeping with a string of recent cases, the High Court applied an approach to interpretation which factored in the commercial rationale and background to the negotiations in order to interpret the disputed (and arguably flawed) terms of the relevant contracts.  Both cases underline the point that New Zealand courts will seek to apply a commercial (and not a “strict” or “literal”) approach to contracts interpretation – especially where the strict approach would yield a commercially absurd outcome to the interpretation of the disputed subject matter.

A case of Tuatara

There have been two important hearings involving the investment by the McKenzie family’s well-known investment vehicle (Rangatira) in the craft brewer Tuatara.

The existence of a dispute came about after Rangatira agreed, in 2013, to acquire some of the founders’ shares and invest new equity which (in aggregate) would give it a 35% stake in Tuatara.

The vehicle for the investment was a document labelled an ‘Investment Agreement’.

In dispute was a provision in the Investment Agreement under which Rangatira would be required to pay to the vendors and to Tuatara additional sums (the ‘Contingent Purchase Price’ and the ‘Contingent Subscription Price’ — collectively the ‘Contingent Payments’) if either of two “trigger” events occurred.  Specifically, the litigation focused on the trigger for an ‘Exit Event’ – being the sale of all the sale of all (or substantially all) of the assets of Tuatara or the shares of Tuatara which actually or by implication valued the business of Tuatara (or Tuatara itself) at greater than $12million.

The parties disputed whether an Exit Event had occurred as a result of the sale of all of the shares in Tuatara to DB at a price in excess of $12m – which was completed in January 2017 (almost 3 ½ years after the Investment Agreement had been signed).

The focus of the dispute was a construction issue under the Investment Agreement – as to whether such an Exit Event was subject to a sunset period which expired on 31 December 2015.

The amount is dispute (if a Contingent Payment was due) was approx. $921k – and because the vendors considered that Rangatira had no defence to the claim, they applied for summary judgment.

In the first decision, the High Court declined to give summary judgment to the Tuatara founders against Rangatira.

As a result, the matter went to a substantive hearing (also in the High Court).

By applying the usual parameters for contractual interpretation (looking at the plain and unambiguous meaning of the relevant clause – and then testing whether that lead to a result that flouted common sense), the Court declined the claim against Rangatira and found that the Contingent Payment was not triggered for an Exit Event that occurred after the sunset date.

On this basis, the judge concluded that it was likely that the absence of specific reference to the sunset date in the definition of an Exit Event was an oversight and that both parties understood that an Exit Event had to happen prior to the sunset date to result in the obligation to pay.

In reaching this conclusion, the judge examined evidence of the negotiations between the parties and the background information that would have been available to them.  Amongst other things, included a drafting note by the founders’ lawyer in a draft of the Investment Agreement that the Exit Event was “not anticipated” against submissions and evidence on behalf of the founders that it was highly likely (on the basis of previous negotiations before the Rangatira took its stake) that Tuatara would be sold to a major industry brand – and that they were concerned that the obligation to pay the earn-out would not be defeated should this occur.

The judge also considered the commercial objective which underpinned the earn-out, namely that of facilitating the sale of the shares to Rangatira at a price that reflected the actual value of those shares.  Importantly, it was the value of the shares at the time the Investment Agreement was entered into that was of critical importance – not the value of the shares potentially at some distant time in the future.

As a result, he concluded that an interpretation that the exposure to pay the earn-out, triggered by an Exit Event, must expire at the sunset date – as being commercially sensible.  In doing so he rejected the submission of the alternative interpretation, which would require the Contingent Payments to be made potentially many years after the agreement, as not being commercially sensible.  It is also inconsistent with the principal objective of the relevant provisions in the Investment Agreement was to establish a fair value for Tuatara as at the date Rangatira acquired its stake rather than at some unspecified date potentially in the distant future.

The commercial approach to the interpretation was needed to avoid what was labelled a commercially absurd outcome that might have otherwise been yielded by a “strict” interpretation of the relevant wording.  In this regard, the analysis of the judge in the summary judgment application was more detailed and (if anything) more compelling.

The Hi-Tech case

In 2015, Hi-Tech agreed to sell its effluent management business to Waikato Milking Systems for a total of $6.25m – but under the Sale and Purchase Agreement (SPA) payment of two separate tranches of an aggregate of $1.5m (the Contingent Sums) was conditional on certain trigger events.

Those trigger events were an earn out mechanism based on the business achieving a threshold level or EBITDA (or the final farm milk gate price announced by Fonterra for the relevant season (excluding dividends) being above a specified threshold).

Hi-Tech did not suggest that either of the trigger events occurred – indeed as the judge noted, it appears to be most unlikely that any trigger event will occur.  Instead, What Hi-Tech sought summary judgment on the basis that Waikato Milking Systems had become liable to pay the Contingent Sums under an acceleration clause in the SPA.

The acceleration clause provided that liability to pay the Contingent Sums in the event of a change of control of the purchaser, or a sale, transfer, assignment or disposal of the business (or a part of it) by the purchaser.

Hi-Tech alleged that in mid-2017 Waikato Milking Systems made some significant changes to the business, including the closure of the servicing and parts operations previously carried out from the business’ premises in Morrinsville.  It considered that this constituted a transfer or disposal of part of the business – triggering the acceleration.

In the High Court, the same Associate Judge who heard the Tuatara summary judgment application found that the servicing work carried on from the Morrinsville premises constituted part of the business.  As a result, he concluded that there was no reasonably arguable defence to Hi-Tech’s claim that there has been a disposal of part of the business – and that the Contingent Sums were therefore due and payable (and awarded summary judgment accordingly).

The judge referred to the earn-out as reflect a not unusual commercial situation where parties cannot agree on the value of a company being sold, and so provide for the payment by the purchaser of an additional sum which will be conditional on meeting stated financial performance targets within a stated period.  In such cases he said the intention is to “put to the test” the vendor’s contention that the business being sold is worth the full amount (including the contingent sum or sums), and the purchaser’s contention that it is only worth the “base sum”, that it is prepared to pay up front.  He continued by noting that the purpose of the earn-out would obviously be defeated if the size of the business being sold were significantly reduced during the earn-out period by the transfer or loss of part of the business.  (In this case the servicing work carried out from the Morrinsville premises accounted for approx. 12% of the revenue of the business at the time of the SPA).

As an interpretation matter, the Judge followed a similar process to that which he used in the Tuatara summary judgment hearing (and which was also followed in the substantive Tuatara hearing) by noting that the earn-out and acceleration clauses were to be read in the relevant context – which included the commercial objectives of the earn-out.

In the Hi-Tech case, the judge accepted Hi-Tech’s submissions that the acceleration clause did not necessarily require the sale of some asset, or legal right, by the purchaser, for liability to pay the Contingent Sums to be triggered.  Consistent with that interpretation, the acceleration clause provided that a cessation of the business would be sufficient to trigger liability to pay the Contingent Sums – cessation of the business could clearly occur without any sale or transfer of any asset or legal right of the business.

Concluding comments

Both Tuatara judgments and then the Hi-Tech case build on the understanding about the approach of the New Zealand courts towards the interpretation of commercial contracts.

In turn, the judgments also highlight the practical difficulties that must be addressed mean negotiating and drafting an earn-out.  Regardless of whether a business sale is a standalone acquisition or a bolt-on acquisition undertaken by a larger business – it is almost inevitable that the purchaser will make changes to the business.

Earn-outs and any accompanying acceleration protection need to be considered carefully.  It is not always possible to predict or legislate for future developments.  And business is, by its nature, dynamic.

Further information

If you would like more information about any of the matters discussed in this note, please contact me.