Best efforts obligation in earn-out arrangement? AMS explains!

An earn-out arrangement is a type of deferred payment of the purchase price that depends on the results after the takeover. In recent proceedings about an earn-out arrangement, the court found that the buyer has a best efforts obligation to achieve as high a profit as possible during the earn-out period. The consequences of violating such an obligation are far-reaching.  Dutch Corporate lawyer Hidde Reitsma explains.

No profits, so no earn-out?

In this case the sellers sold their company to the buyer. Based on an earn-out arrangement, subsequent payments would depend on the results over 2008-2011. After this period the buyer informed the sellers that the agreed turnover target had not been achieved. Did this mean that things were over for the sellers? In fact, no. In proceedings against the buyer, they claimed payment of the earn-out.

Earn-out essential part of the purchase contract

The court finds that the earn-out was an essential part of the purchase contract for the sellers. This meant that the buyer was also obliged to make his best efforts to achieve maximum turnover and profits. This best efforts obligation is not only a consequence of the purchase contract, but also stems from the requirements of reasonableness and fairness.

Altering business operations at the expense of the profits

According to the court, the sellers could assume that the company would be run in a similar manner after the takeover, also to achieve the turnover and profit targets of the earn-out. Instead, immediately after the takeover the buyer altered the business operations and the commercial structure which put pressure on the profits. This resulted in underutilization of the higher management.

After expiry of earn-out period suddenly large profits

There was also substantially more depreciation than usual and a profitable component of the business was transferred to a subsidiary. It is therefore obvious that the upward trend of the profits of the company in the years prior to the takeover was no longer achieved. It was a particularly bitter pill for the sellers to swallow that from 2012 onwards – so after expiry of the earn-out period – the company suddenly did very well and was extremely profitable.

Failure in earn-out arrangement

The court found that in light of these circumstances the buyer not only breached his best efforts obligation, but also (intentionally) prevented achieving the earn-out. This means that the buyer failed in complying with the earn-out arrangement. The court sentences the buyer to comply with his obligations based on the earn-out as if all targets of that arrangement had been achieved. The buyer therefore has to be pay the sellers their earn-out.

Lawyer when drafting a takeover contract

In my opinion this ruling spells out the problems in agreeing to an earn-out. Although the turnover can be assessed based on annual accounts drawn up by a certified auditor, it is more difficult to determine the efforts made by the buyer. In this case the buyer used all possible means to put pressure on the profits unless he was free of the earn-out obligation. The court was justified in preventing this.