Earnout provisions are useful tools that can bridge the gap between the competing perspectives of sellers and buyers on value in M&A transactions by linking the ultimate purchase price paid for the target business to certain metrics achieved within a specified period of time. Often, earnout clauses will contain acceleration provisions that can expedite the release of certain seller payments as a result of the conduct of the buyer or management of the target post-closing, or the occurrence of certain events, such as a change of control or subsequent sale of the target company.
This article specifically focuses on a recent Ontario Superior Court of Justice (the "Court") decision, Project Freeway Inc. v. ABC Technologies Inc. ("Project Freeway"), that addressed whether certain post-closing transactions could trigger the acceleration of an earnout contained in a share purchase agreement ("SPA"). The decision provides valuable insight on how Canadian courts may interpret key contractual terms such as "material" in the context of an earnout provision and will be of interest to anyone involved in structuring, negotiating or enforcing earnout provisions in Canadian M&A transactions. The decision also sheds light on how business context plays into legal interpretation when it comes to earnout provisions post-closing.
Our previous articles on earnout provisions can be found below:
- Examining the Utility of Earnout Provisions in M&A Transactions
- Closing the Value Gap Using Earnouts in Life Sciences M&A
Background
In late 2022, ABC Technologies Inc. ("ABC") acquired Windsor Mold Group Companies ("Windsor Mold") from Project Freeway Inc. ("Freeway"). The transaction included a single cash payment of US$165 million at closing and a post-closing earnout of $26,461,000, which was contingent on Windsor Mold meeting certain financial performance benchmarks following its acquisition by ABC and would be paid out in three tranches: the first earnout period beginning on the closing date and ending on the six-month anniversary of closing; the second earnout period beginning on the first day following the end of the first earnout period and ending on the one-year anniversary of closing; and the third earnout period beginning on the first day following the second earnout period and ending on the two-year anniversary of the closing (the "Earnout Period"). The SPA also included a clause stating that if, during the Earnout Period, ABC sold, transferred or licensed a "material portion" of Windsor Mold's assets without Freeway's consent, the full earnout amount would immediately become payable.
Key Facts of Project Freeway
Upon closing of the transaction, ABC completed two transactions without consulting Freeway, which Freeway asserted triggered the acceleration of the earnout payment under the SPA. The first of these transactions involved a sale and leaseback of Windsor Mold's land and buildings, pursuant to which property owned by Windsor Mold was sold to a third party and then leased back to Windsor Mold. The second transaction was a factoring arrangement pursuant to which ABC sold Windsor Mold's accounts receivable to its own lender without notifying or receiving consent from Freeway.
Having not been previously consulted about either transaction, Freeway argued that these transactions amounted to the sale or transfer of a "material portion" of Windsor Mold's assets, thereby triggering the acceleration clause and the associated full earnout payment. Conversely, ABC maintained that neither transaction triggered the acceleration clause as both transactions were standard financing arrangements that neither altered the core business operations of Windsor Mold nor impacted the earnout targets set forth in the earnout provision in the SPA.
Court's Ruling: Materiality Must Be Understood in Context
A central issue in the case was how to interpret the word "material" in the context of the earnout provision and nature of the transactions in question. Freeway took a strictly quantitative view in its analysis, pointing to the sheer value of the sale and leaseback of Windsor Mold's land and buildings, which had a transaction value that amounted to approximately 59% of the original purchase price under the SPA. As a result of the value of that transaction, Freeway argued that a "material portion" of Windsor Mold's assets had been transferred by ABC and, as a result, the earnout acceleration clause was triggered.
The Court disagreed, rejecting the idea that materiality could be judged solely by the size or value of a transaction in the earnout context. Instead, the Court adopted a contextual approach, emphasizing that materiality must be assessed based on whether the transaction had an actual impact on the business's ability to achieve the earnout performance targets. In this case, the Court asserted that the sale and leaseback transaction did not disrupt business operations, as Windsor Mold continued operating in the same locations with the same equipment, employees and customers. Similarly, the Court determined that the factoring arrangement only affected the timing of when cash would be received by Windsor Mold, not the financial performance or operations. As such, the Court found that neither transaction affected Freeway's ability to achieve the earnout milestones in the SPA and did not, individually or collectively, trigger the acceleration clause.
The Court's decision also considered the extent to which Freeway knew about the proposed post-closing transactions, as well as when they knew. ABC successfully presented evidence that Freeway was aware of the sale and leaseback transaction before closing, had helped arrange site inspections by the eventual purchaser of the real estate and had not raised any objections until after learning the first earnout payment would not be made as a result of Windsor Mold failing to meet the applicable financial milestones in the SPA. The Court agreed with ABC that this knowledge undermined Freeway's claim.
The Court concluded that it would be commercially unreasonable for Freeway to stay silent about a known transaction and later attempt to rely on it to trigger a windfall payment. This aligned with the Court's reiteration of the importance "that a contract be interpreted in a way that 'accords with sound business principles' and avoids 'a commercially absurd result.'"
Key Takeaways From Project Freeway
The decision in Project Freeway provides a variety of helpful insights regarding the legal interpretation of earnout provisions:
- Context Matters: Courts are unlikely to adopt rigid formulas for interpreting contractual terms like "material." They will look at whether a transaction affects a target company's ability to achieve earnout milestones and generate payments for sellers, not just the actual or proportional size of a transaction of the target that could accelerate a payment, as well as the intention of parties as demonstrated in transactional documents, such as looking to a letter of intent "for the purpose of ascertaining background facts at the time the SPA is entered into."
- Commercial Logic Guides Interpretation: Courts typically aim for practical results. If a seller knew about a transaction and did not object to it and then later tries to assert that the transaction impeded its ability to achieve an earnout payment thereby accelerating the payment of same, a court is unlikely to reward the seller with a windfall in order to avoid a "commercially absurd result."
- Silence Can Signal Consent: Parties who know about potentially problematic actions and fail to object may be seen by a court as having accepted the risks that flow as a natural consequence of those actions.
Lessons for Dealmakers Considering an Earnout
The decision also offers some key lessons for businesses and professionals involved in M&A:
- Be Precise When Drafting Earnout Clauses: If certain transactions are meant to trigger the acceleration of an earnout payment, the universe of those transactions should be clearly articulated in the deal documents. Ambiguous terms like "material" may not be interpreted as intended.
- Operational Impact Is Key: It is not just about what was sold but is also about how the business runs after the transaction. If there is no disruption, the case for acceleration weakens, subject to the particular language of the earnout provision. The bar for claims such as that featured in Project Freeway is high, so be sure to draft earnout clauses accurately and strategically when using them in purchase agreements to ensure any argument for or against acceleration is as clear and obvious as possible.
- Ordinary Course Transactions and the Need for Clarity: Common financing arrangements such as sale and leaseback transactions and factoring deals, when done in the ordinary course and without disrupting business, should not be expected to trigger the acceleration of earnout payments, again, subject to the particular language of the earnout provision. Clarity is king and clear communication about potentially sensitive issues should be practised and encouraged to limit the likelihood of future disputes and reasonable claims for acceleration.
Conclusion
The Project Freeway decision reinforces the notion that earnout clauses must be drafted carefully, with special attention paid to the business context and the intention of the parties when coming to an agreement. Courts will look beyond the surface of transactions to assess their true impact on the business, favouring outcomes around earnout accelerations that make commercial sense. For sellers hoping to rely on acceleration clauses, the burden of proof is high and silence or inaction can seriously undermine the success of a claim for acceleration.
The Capital Markets Group at Aird & Berlis LLP will continue to monitor matters related to earnout provisions in M&A transactions. If you are a business owner or a potential buyer considering the use an earnout in an M&A context, or if you have any questions on how to best navigate the use of an earnout provision in the sale or purchase of a business, please contact the authors or a member of the group.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
