Interpretation of an earn-out arrangement in case of unforeseen circumstances
In a published judgement of the Dutch district court of Northern Netherlands of 13 July 2016, the court ruled on the interpretation of an earn-out arrangement (ECLI:NL:RBNNE:2016:3357). This case shows that the use of an earn-out can often lead to disputes. In this case, Amdico (as seller) and Clafis (as buyer) disagreed as to whether the buyer was required to pay part of the purchase price that was agreed upon in the earn-out arrangement, even if the company that had been acquired suffered losses in the year following the acquisition.
An earn-out is a regularly used tool in the mergers & acquisitions practice. Generally, an earn-out entails that a part of the purchase price is paid after the acquisition has been completed. In this case the amount of the purchase price was dependent on the profit that the acquired company would make in the financial year following the acquisition. The parties agreed on the following earn-out text:
“if the company achieves a gross result of less than € 160,000, seller will pay buyer a part of the remaining part of the purchase price in proportion to the difference between the achieved result and the amount of € 160,000, but at least an amount of € 50,000.”
The company, however, achieves a negative result in the financial year following the acquisition. When seller requests buyer to pay the amount of € 50,000, buyer refuses to pay. According to buyer, the amount is only due in the event that the company has made a profit. Subsequently, seller initiates legal proceedings to enforce payment.
The court starts by setting out the judicial scope that is relevant for deciding this matter. The court states that the interpretation of the earn-out will not only be done by using a purely linguistic approach, but also entails the meaning that both parties could reasonably attribute to the earn-out arrangement, as well as what both parties could reasonably expect from each other in this respect (the so-called Haviltex-rule). Furthermore, circumstances like the nature of the transaction, the size and degree of detail of the earn-out arrangement, as well as the manner in which it was concluded are important.
Taking this scope into account, the court decides that it follows from the wording of the earn-out arrangement that seller shall pay an amount of at least € 50,000 as a remaining part of the purchase price, if the company achieves a gross result of less than € 160,000. The condition that the company must have made a profit does not follow from the wording of the earn-out arrangement. Since buyer did not state any other specific facts or circumstances that indicate that there is a link between the text of the earn-out arrangement and the condition that a profit must have been made by the acquired company, the court rules that a linguistic explanation of the arrangement is decisive. Therefore, the court rules that buyer must pay seller the amount of € 50,000.
It is noteworthy that the court does not take into account the fact that the wording of the earn-out agreement has mixed up the references to seller and buyer. Apparently, the court considered that this mistake was not important enough to mention it.
The conclusion that can be drawn from this decision of the court is that it is always recommendable to keep all (unforeseen) circumstances in mind when agreeing on an earn-out arrangement, including the possibility that the company will suffer a loss and that it is always recommended to put down in writing the consequences of such circumstances.