When questions arise about the leadership of a family enterprise, it’s not uncommon for family members to consider the option of a sale as a possible outcome of the process. There are many reasons why maintaining ownership of the family enterprise may not be feasible; family members may not have the financial resources available to dedicate to the business, family members established as management are in health or mental decline, or perhaps no consensus can be reached regarding potential family successors to maintain control of the business. Whatever the reason, the end result may be the sale of the family business. When acquiring a small or family business, buyers wishing to mitigate their risk frequently look for an earn out.
So what is an earn out? Earn out refers to a pricing structure where the sellers must “earn” part of the purchase price based on the performance of the business following purchase. In an earn out, part of the purchase price is contingent on the target company achieving certain, predetermined financial goals.
Earn outs are commonly used when a buyer has doubts about the company’s growth and estimated earning potential. A typical earn out is structured over a three to five year period following the acquisition and may involve anywhere from ten to fifty percent of the purchase price being deferred over that period. Earn outs are beneficial to buyers who do not necessarily have the expertise to run a target business after closing. It keeps the previous owners involved following the acquisition, which offers stability to the current client base. If the company fails to hit the stated goals or breaks the contract, they forfeit the remaining purchase price.
While earn outs provide protection for the buyer, most often they pose a substantial risk for the seller. A recent case in the Delaware Court of Chancery, Airborne Health, Inc and Weil, Gotshal & Manges LLP v. Squid Soap, LP is yet another example of the propensity of earn outs to go bad and provides reminders of common pitfalls parties should attempt to avoid when drafting these provisions.
The controversy arose from the earn out agreement for the acquisition of Squid Soap by Airborne Health, Inc. Squid Soap, LP developed a germ-prevention product for children designed to increase the amount of time they spend washing their hands. Airborne Health, Inc. acquired Squid Soap’s assets by earn out agreement that paid Squid Soap $1 million at closing, with an earn out of up to an additional $26.5 million if certain targets were achieved. Squid Soap had concerns whether or not Airborne would take the necessary steps to ensure the company reached those goals, and included terms which required Airborne Health to successfully market the product. The agreement provided that Airborne had to return the assets to Squid Soap if Airborne had not spent $1 million on marketing the product and achieved $5 million in net sales in the first 12 months following the closing.
While Airborne attempted return Squid’s assets on several occasions, for its part, Squid Soap preferred to pursue litigation against Airborne. Airborne and its counsel, Weil, Gotshal & Manges, LLP, succeeded in having the claims against them dismissed and having the court declare Airborne had not breached its agreement with Squid Soap.
The takeaways? Earn outs are fraught with risk and parties that use them should understand the likelihood of post-closing disputes.