Two recent New Zealand cases highlight the risks associated with earn-out arrangements in private M&A. In both cases, the High Court considered the rationale and circumstances of the transaction to assist with interpreting the disputed contractual provisions. Both cases confirm the black letter law approach to contract interpretation is ‘old law’ and courts will consider ‘what is commercially sensible’ when resolving interpretation disputes between contracting parties.
The Malthouse Ltd v Rangatira Ltd  NZHC 816
Tuatara Brewing Company Ltd was a privately-owned craft beer company, whose shareholders included The Malthouse Ltd (TML). After a successful first decade of operations, the company required significant capital investment. A private equity investor, Rangatira, was enticed onto the investment scene.
In 2013 it was agreed that Rangatira would acquire 35% of Tuatara’s issued shares, however there was disagreement over valuation. Consequently, the agreement contained an ‘earn-out’ clause. Rangatira would pay $3.5 million upon settlement. Rangatira would also become liable to make contingent payments totalling $1 million, to the shareholders and Tuatara, if:
- The EBITDA hurdle was met on or before the contingent sunset date (in 2015); or
- An exit event occurred which valued Tuatara at greater than $12 million.
The EBITDA hurdle was not achieved by the contingent sunset date. TML felt this was due to a change in accounting practices at Tuatara – leaving a somewhat ‘bitter (beer) taste’. The court’s decision was more concerned with the occurrence of an exit event.
In 2017, 100% of the shares in Tuatara were sold to DB, an industry player, for more than $12 million. Prior to completion of that sale, a dispute arose as to whether this was an exit event obliging Rangatira to pay the contingent payments. The issue for the court was whether the exit event was subject to the contingent sunset date, such that it had to occur before that date for the additional payment obligation to arise.
Proceedings were filed. The DB acquisition proceeded. Meanwhile, the parties entered into a deed providing that if Rangatira was found liable to pay, a reduced amount would be paid to the prior shareholders (excluding Rangatira), not DB.
Application after sunset date
The High Court found for Rangatira, holding that payment upon an exit event was not intended to apply after the contingent sunset date.
The court engaged in an interpretation exercise. It considered evidence of the prior negotiations and background information that would have been available to the parties. This included a drafting note in a prior draft of the agreement that the exit event was “not anticipated” against contrary evidence that it was almost certain Tuatara would be entirely sold in the future, albeit not the immediate future. In the court’s view, this showed the parties had ‘not anticipated’ the sale of the business for more than $12 million prior to the contingent sunset date. This in turn indicated that payment upon an exit event was not intended to occur beyond the contingent sunset date.
The lack of any specific reference to the contingent sunset date in the relevant clause did not mean that the parties “clearly thought about the issue” and deliberately intended the clause to survive that date. The court found this omission was likely an oversight.
The court had regard to the commercial objective underlying the earn-out provisions. The court held that these were designed to facilitate the sale of the shares to Rangatira at a price that reflected the actual value of those shares, at the time the agreement was entered into. If a qualifying exit event in the distant future triggered liability, the earn-out provisions would not meet that commercial objective. As such, a commercially sensible interpretation was that the right to receive payment upon an exit event was intended to expire at the contingent sunset date.
The court found it was appropriate to apply the sunset date concept to the relevant clause, namely that “if an Exit Event occurs in the timeframe specified ... the Contingent Payments shall be immediately due and payable”.
While the court read words into the agreement that were not there, the outcome reflects what an escalation clause would usually provide and avoided a literal interpretation that meant the earn-out payment may have been payable beyond the short-term future, if at such time the business was sold. Such an outcome would have been commercially absurd, and the court took an approach which avoided that.
Hi-Tech Ltd v Waikato Milking Systems Partnership Ltd  NZHC 1413
Waikato Milking Systems (WMS) agreed to purchase Hi-Tech in September 2015. The total purchase price was $6.25 million.
As in The Malthouse case, the purchase agreement contained an earn-out clause to bridge the gap in assessment of value between purchaser and vendor. As part of the purchase price, ‘contingent sums’ of $600,000 and $900,000 were to become payable in 2018 and 2019 respectively conditional on certain trigger events occurring. The specified trigger events referred to EBITDA of the business and the final farm gate milk price for the preceding financial year exceeding specified thresholds.
It was not alleged that these triggering events had occurred. Instead Hi-Tech relied on an acceleration clause which provided that WMS would become liable to pay any future contingent sum in the event of a change of control of the purchaser, or a sale, transfer, assignment or disposal of the business by the purchaser.
Was acceleration clause triggered?
In June 2017, WMS closed the servicing and parts operation of the business previously carried out from the manufacturing plant in Morrinsville. Hi-Tech alleged that this constituted a transfer or disposal of part of the business and consequently the remaining earn-out payments were payable in full. WMS denied that the acceleration clause had been triggered at all. Hi-Tech applied for summary judgment.
The High Court found for Hi-Tech. The court held it was not reasonably arguable that WMS did not transfer or dispose of part of the business, when it ceased providing servicing work that constituted almost 12% of the total revenue of the business at the time. WMS was required to pay Hi-Tech the total of the contingent sums, being $1.5 million.
As in The Malthouse case, the court found the relevant clause was to be read in context and with the relevant commercial purpose of the clause in mind. One purpose of an earn-out provision is to ‘put to the test’ a vendor’s contention that the business being sold is worth a larger amount than the purchaser has contended, using stated financial performance targets. This purpose could be defeated if the size of the business being sold was significantly reduced during the earn-out period. The transfer or loss of part of the business could make it more difficult or effectively impossible for WMS to achieve the EBITDA targets. The acceleration clause was intended to protect Hi-Tech from this eventuality.
The agreement did not require the sale of some asset or legal right by the purchaser to another party. Cessation of the business or part of the business was enough for liability to be triggered. The relevant clause listed ways in which WMS could relinquish possession of the business (or part thereof) and inhibit the likelihood of the business achieving the EBITDA targets. Selling or transferring the business was one of these ways. Giving up the business, or part of it, was another way in which this could occur. Such an action was held to be a disposal.
The above two cases illustrate the potential difficulties that earn-out provisions present. Where a purchaser takes ownership and control of a business that the vendor has a material financial interest in, there is inevitable tension. The contractual provisions need to be carefully crafted and considered by both parties to ensure the right balance of interests is struck. Where there is uncertainty in the application of those provisions, the courts will consider what is commercially sensible in deciding the case.
John Horner firstname.lastname@example.org is a partner at Quigg Partners, specialising in Mergers and Acquisitions.