Earn-out mechanisms - useful guidance

It is increasingly common in this uncertain economic climate for a significant part of the purchase price for a target business to be subject to the post-completion performance of the business. Given that following completion the target will be under the buyer's ownership, it is usual for the seller to insist on having a degree of contractual control over the buyer's conduct of the business during the earn-out period, through for example:

• positive obligations to maximise the profits of the business;
• restrictions against certain actions which might artificially reduce the profits.

The High Court decision in the case of Porton Capital Technology Funds and Ors v 3M UK Holdings Ltd & Anor provided some useful guidance on how such restrictions are likely to be interpreted, and also on the circumstances in which a contracting party can reasonably withhold consent to a particular action.

In the Porton case, part of the purchase price was based on a level of post-completion net sales. The purchaser was obliged:-

• to market the target's product actively
• diligently to seek regulatory approval for it
• not to cease carrying on the business without the written consent of the sellers, not to be unreasonably withheld or delayed.

The purchaser abandoned clinical studies required for regulatory approval because of unexpectedly poor performance, and subsequently requested the sellers' consent to a cessation of the business for the same reason. The sellers refused consent, whereupon the purchaser wound up the business during the earn-out period.

The court held that an obligation to "diligently" seek regulatory approval did not impose a separate obligation of reasonable care. The way in which the clinical studies had been carried out was therefore irrelevant, but the purchaser had breached its obligation in the agreement by abandoning them altogether. The court did not, on the evidence, accept the purchaser's argument that to continue the studies would be futile because of the performance issues identified.

The obligation to actively market a product implied a substantive effort to market it to new customers, which again the purchaser had ceased to do after a period of time.

Finally, the purchaser had argued that the seller's refusal of consent for cessation of the business was unreasonable and therefore a repudiation of the contract. The court applied the following principles in making its decision:

• the burden was on the purchaser to prove that the refusal was unreasonable
• the sellers' refusal did not need to be right or justified, just reasonable in the circumstances
• the sellers were entitled to have regard to their own interests in maximising the earn-out payment and were not required to balance these with the purchaser's interests.

The court found that as the reasons for the business failure were complex, it was reasonable for the sellers not to accept the purchaser's explanations at face value and to consider that further investigation was required. It was also reasonable to suspect that the business failure was partly caused by the purchaser's breaches of the sale agreement.

Whilst the sellers had rejected the specific request for consent, they had not implied that no consent would be given under any circumstances. The sellers' refusal was therefore reasonable and was not a repudiation of the sale agreement.

The case illustrates the importance of carefully documenting the ongoing rights and responsibilities of the parties in an earn-out scenario. Furthermore, any party who is only allowed to refuse consent if they act reasonably should consider carefully how any refusal is communicated in order to avoid any suggestion of a repudiation of the underlying contract.