Sometimes a seller of a business will agree to take a portion of the purchase price based upon the future performance of the business. This part of the purchase price is called an earnout. The calculation of the earnout is based upon a formula that is contained in the written purchase agreement.
Earnouts are risky for the seller because the future performance of the business depends upon the buyer – not the seller. Also, the seller runs the risk that the buyer (who controls the business books and records) will cook the books to avoid or reduce the earnout.
In this case the buyer purchased seller’s interest in a limited liability company effective the beginning of 2016. Part of the purchase price was an earnout of 50% of the company’s net income allocated to buyer for 2016 through 2018.
The seller sued the buyer in a Pennsylvania federal court claiming that the buyer underpaid seller’s 2016 and 2017 earnout.
The seller claimed that the buyer underpaid him partly by deducting as expenses fees paid to affiliates of the company, that were owned in part by the buyer. The seller pointed to the formula for net income contained in the purchase agreement which did not allow these fees to be included as expenses for calculation of the net income earnout. The court agreed.
The seller also claimed that the buyer did not include all the company’s revenue in the calculation of the net income. Specifically, that buyer did not include revenue that was earned by the company but not received by the company.
The court did not buy this argument. It noted that revenue was described in the purchase agreement as revenue earned by the company. But this language was later followed by language that said for purposes of the purchase agreement revenue would be recognized when received by the company.
This case is referred to Warren Hill, LLC v. SFR Equities, LLC, Civil Action No. 18-1228, United States District Court, E.D. Pennsylvania, (February 8, 2019).
The formula for the earnout used in the purchase agreement worked. The court was able to resolve the two disputes about calculation of the net income by referral to the formula.
In 20/20 hindsight, to avoid this fight, the seller and the buyer could have agreed to a fixed purchase price to eliminate a later fight over the amount of the earnout.
Even moving up the income statement for an earnout formula based not on net income but revenue would eliminate any fights over expenses.
By John McCauley: I help businesses minimize risk when buying or selling a company.
Telephone: 714 273-6291
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