Mapping risks and preventing disputes involving earnout clauses

It is customary in M&A practice: in light of uncertainties in determining the actual value of a business, especially vis-à-vis its future profitability, or to account for any unexpected post-closing contingencies, parties often agree on a deferred conditional payment mechanism – earnout arrangements – by which the purchase price is payable in full or in part only if certain financial or non-financial targets are met by the business at a given point after closing.

At the time earnout payment may become due, buyer is already in control of the target company, which means that it may be in a position to affect the achievement of the earnout conditions. In order to avoid potential disputes on the validity and enforceability of such provisions, some Brazilian law aspects should be properly addressed while the parties are negotiating their M&A transaction documents.

Pursuant to the law, the purchase price may be set as a function of external indexes or parameters, as long as they can be objectively assessed; in addition, it may not be conditional upon acts or facts over which only one of the parties has discretion and control. Therefore, earnout provisions must contain clear and objective milestones (e.g.: one or more financial benchmarks, certain regulatory approvals, development of previously specified new products etc.). It is also advisable that the calculation of the additional payment follows simple and clear metrics.

By fulfilling such requirements, the parties can better safeguard not only the validity but also the enforceability of the earnout provision. For instance, the São Paulo Court of Appeals held in 2016 that fast-track enforcement of an earnout clause – allowing the immediate attachment of assets prior to any merits discussion – is admissible when the calculation of the amount payable is based on objective criteria (e.g., EBITDA).

Another important matter that the parties should regulate in the earnout clause is seller’s audit rights throughout the earnout period. The provision is particularly important when seller’s representatives are not engaged by the target company in any managing position. In cases such as these, the seller is left in the dark as to whether the earnout goals have been achieved. Carefully crafted language is important to both parties. It may allow seller to effectively monitor the achievement of agreed milestones; conversely, it may help buyer limit the amount of sensitive information made available to seller, mitigating risks of unfair competition and similar anti-competitive behavior on the part of seller.

In the absence of such provisions, the São Paulo Court of Appeals has held – in 2012 and 2013 – that seller has the right to access documents and information necessary to verify the fulfillment of earnout conditions (in that particular case, commercial agreements entered into by the target company). The court based its opinion on the fact that: (a) seller was dismissed from the managing position, which prevented him from monitoring business activities; (b) the risk of unfair competition would be mitigated by a 15-day delay between signing of each commercial agreement and its disclosure to seller; and (c) the party in favor of which a condition was set has the statutory right to act in order to preserve its potential rights.

By the same token, in a 2018 precedent, the court granted a neutral expert access to documents and agreements which it deemed necessary to verify the fulfillment of earnout conditions, even though seller had no auditing rights under the M&A agreement.

Evidently, this could prove a real predicament for buyer and the target company depending on the amount and sensitivity of the information to be disclosed – especially considering that the court may not be familiar with the business and may be led to order the disclosure of more information than what is strictly needed.

Furthermore, because earnout-related disputes typically involve controversy over whether a certain condition was or was not met, parties should pay close attention to the statute in that regard: (a) if a party deliberately prevents a condition which benefits the counterparty from being met, then this condition is deemed fulfilled; and (b) conversely, if a party acts to artificially implement a condition which benefits itself, then this condition is deemed unfulfilled.

Several situations require particular care during the negotiation of M&A agreements. These include cases in which seller may be dismissed from managing positions, changes to business activities, procedure, and timeframe for development of new products and lines of business. Court precedents misinterpreting earnout provisions in cases such as these are certainly not unheard of.

Earnout mechanisms can cut both ways: they are an important means of achieving the intended win-win objective and circumvent inevitable business valuation gaps, but they can create trouble if they are poorly drafted. Given how Brazilian law and courts work, it is paramount to regulate matters that may impact the validity and enforceability of conditional payments in a thorough and unambiguous manner – or brace for a dispute further down the road.

L&S Authors

Nicholas Schiappacasse Cruz

Nicholas Schiappacasse Cruz

Renato Din Oikawa

Renato Din Oikawa


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