Earn-Outs - The Court Fills The Gaps

Earn-out mechanisms are commonly used in M&A transactions involving the sale of shares or assets where the price (or part of it) is determined by reference to the future performance of the target company or business. There are as many earn-out formulations as there are transactions, but arguably the most common determinant is profits (as opposed to, say, turnover or net assets). Since earn-outs are commonplace, there is a substantial body of knowledge and experience about the key commercial issues and these are always hotly negotiated by sellers and buyers and their respective advisers. However, there has been scant judicial precedent on earn-outs. Until, that is, the recent High Court decision in Porton Capital Technology Funds v 3M UK Holdings Ltd.

Cutting through the detail, the earn-out provision under dispute imposed an obligation on the buyer to "diligently" seek regulatory approval and "actively" market the target's products. However, as it turned out, the buyer decided to terminate the target business after it acquired it, as it was unprofitable. As a consequence of the termination, no earn out payments were made to the sellers, hence the claim brought by them for breach of the obligations just referred to.

The court agreed that the buyer did not "diligently" seek regulatory approval, as it failed the objective test of reasonable application, industry and perseverance. The court also took the view that the buyer did not "actively" market the products...