The “earn out” has its origin in private equity deals where the seller commits to a projected earnings level to accommodate a high sale price expectation that the buyer will only have to pay if the business achieves that target.
So when Sunshine Coast chartered accountants Complete Business Strategies agreed in October 2010 to a local competitors’ asking price of $1.3 million – valuing their business at one dollar for every dollar of annual income – it was on terms that the price paid was at risk if the business’ gross revenue did not total $2.6 million for the following two years.
The sellers stood to lose $1.00 from the purchase price “for every dollar of deficiency” – not just from the 20% of the purchase price retained by the buyer for two years conditional on the specified earnings being achieved – but also by claw back from the sum handed over at settlement.
The shortfall in billings turned out to be a substantial $1.03 mil. By strict application of the contract formula, the purchase price would have been brought down to just $270k notwithstanding CBS had – on the face of it – successfully acquired annual fees of $800k.
The seller and its principals – self represented at the trial – argued that the earn out claw back was so extreme, it was in truth an illegal penalty. The sale price could be reduced to nil for example, even if the business earned 50% of the target revenue. An unconscionable outcome, so ran their argument, as on the agreed valuation formula, the buyer should have paid $800k for that level of annual fees.
The court did not agree. It found there to be no penalty and nor was the arrangement unconscionable.
“In essence, the parties agreed that $1.3 million should be paid for assets which the vendor guaranteed would produce fees of $2.6 million over two years from the completion of the contract. They agreed that if the assets did not yield that turnover, then the amount to be ultimately paid for the practice should be reduced, dollar by dollar, to make up for the shortfall”.
After allowing for the retention amount of $260,000, the seller company was ordered to repay CBS a further $768,386 but no order was made as against the seller’s principals.
The buyer also sought damages against the principals by reason of alleged breaches of their covenant not to compete in the provision of accountancy services or taxation advice, “throughout Australia for 5 years”.
Having started a “wealth creation and life coaching” business – which did not of itself offend the non compete covenant – evidence was led to show tax advice being provided by the seller to a former client and also of advertisements for general accountancy work.
The court had to decide the reasonableness of the numerous geographic and time period qualifiers nominated in the contract as successively applicable restraints. With little discussion in the judgment, the court allowed as reasonable, the maximum geographical restriction contended for by the buyer of “throughout Australia”, solely on the basis that the client list schedule included a “not insignificant” number of people located across the country.
However the buyer’s argument that the restriction apply for the maximum five years was rejected with the court ordering that only two years was reasonable as such period would allow sufficient opportunity (two successive tax periods) for the buyer to create its own business relationship with the specified clients.
Neither the existence nor extent of any non-solicitation covenant as regards the scheduled clients – separate to the territorial/time based non compete clause – can be deduced from the judgment.
In any event – with many of the other competition complaints being rejected – the court held that the buyer had failed to prove any actual financial loss as a result of even the proven breaches on the seller company’s part.