Ruling highlights earn-out pricing mechanism disputes risk

Earn-outs are a common pricing mechanism in mergers and acquisitions (M&A), where the parties agree that a portion of the purchase price will be paid based on the future performance of the business.

They can be a useful mechanism to bridge valuation gaps and align the buyers’ and sellers’ interests. Sellers can be incentivised to maximise the profits of the business post completion whilst buyers can mitigate valuation risks and overcome cash constraints at completion, or conserve cash for other purposes. However, given that earn-outs introduce a contingent element to the pricing, earn-outs can also be a source of disputes, as the parties may have different expectations or interpretations of the earn-out provisions.

In the recent case of SSABR Pty Ltd v AMA Group Ltd (SSABR v AMA), the Supreme Court of New South Wales clarified some important principles and issues relating to earn-outs in M&A transactions.

Background

The sellers, SSABR and HAAPRC Pty Ltd (Harris & Adams), sold two smash repair businesses to AMA for an upfront consideration plus an "earn-out amount" to be paid in two years' time. The earn-out amount was based on the earnings before interest and tax (EBIT) of the businesses and a multiplier of four. The contract did not contain detailed requirements on how AMA was to conduct the business in the earn-out period.

The parties had entered into binding heads of agreement that set out the terms of the sale, including a worked example of how the earn-out amount would be calculated using the average annual EBIT of the businesses across the two year earn-out period. However, the business sale agreement that was executed by the parties did not include the word “average” in the formula for the earn-out amount, which meant that instead of using the average EBIT number, the drafting aggregated the EBIT across the two years and effectively doubled the potential earn out. The parties did not notice this error at the time of signing the business sale agreement.

SSABR also alleged that AMA breached the contract and engaged in misleading conduct by changing the businesses' contracts and rates with a major insurer, Suncorp, after completion, which reduced the profitability of the businesses.

The court’s decision

The court held that the business sale agreement should be rectified to accord with the parties' agreement by adding the words "average annual" to the beginning of the formula for the earn-out amount. The court was satisfied that the parties had a common intention and understanding that the earn-out amount would be calculated on an average of EBIT per year, as stated in the binding heads of agreement, and that this intention did not change during the drafting of the business sale agreement.

The court relied on the evidence of the parties' negotiations, the heads of agreement, the evidence of one of the directors of the buyer, and the absence of any evidence to the contrary from the sellers. It also noted that the drafting error was not absurd or self-evident, and that this was not a case where the principle of ‘rectification by construction’ could apply. The principle of rectification by construction allows the Australian courts to correct a drafting error by constructing a new term to be read into the contract. The courts can do this where the drafting error is clear and if it is also clear what a reasonable person would have understood the parties to have meant.

The court dismissed the sellers' claims that the buyer breached the contract or acted in bad faith by entering into revised agreements with Suncorp, and lowering the charge-out rate for Harris & Adams after the sale. The court found that the business sale agreement did not impose any restrictions or obligations on the buyer’s post-completion conduct of the businesses, except for the express terms of the business sale agreement.

The court also found that there was no evidence that the buyer knew or intended, before entering into the business sale agreement, to enter into revised agreements with Suncorp or to lower the charge-out rate for Harris & Adams, or that it failed to inform or consult with the sellers about these changes. The court concluded that the buyer did not act dishonestly or unreasonably in making these changes, which were driven by market conditions and Suncorp's demands.

Ultimately, SSABR v AMA serves as a cautionary tale for parties entering into earn-out arrangements. It underscores the importance of meticulous drafting, clear communication, and diligent execution of obligations to mitigate the risks of disputes post completion.

Where the parties wish to incorporate earn-outs as a pricing mechanism, it is important to ensure that the terms of the earn-out are negotiated and carefully and expressly included in the transaction document. The specific achievement criteria should also be clearly set out, such as the measures of financial targets – such as revenue or earnings in a specified period – and operational milestones, such as production development or market penetration.

Parties should seek professional legal advice and ensure that their earn-out provisions are carefully crafted to mitigate risks and uncertainties.