By Jacqueline Monk, Special Counsel

A recent decision of the NSW Court of Appeal shows the financial impact of failing to clearly articulate pricing in deal documentation.

What happened?

In SSABR Pty Ltd v AMA Group Limited, a buyer agreed to buy a business for $4.8 million plus an earn out amount to be paid two years after completion.

The Business Sale Agreement (BSA) signed by the parties stated that:

“The Vendors shall be entitled to the Earn-Out Amount calculated by the Purchaser as follows:

EBIT for the Businesses for the Earn-Out Period MULTIPLIED by 4…”

The Earn-Out Period was defined as “the period of two calendar years commencing on the Completion Date”.

A natural reading of this clause suggests that the earn out amount was to be calculated on the basis of the total EBIT during the two-year earn out period.

However, a Binding Heads of Agreement (HOA), which the parties had signed a month before the BSA, calculated the earn out on the basis of the annual average This would have had the effect of halving the amount of earn out payable by the buyer.

Understandably, when it came time to pay the earn out, the buyer opted for the calculation set out in the HOA while the seller pointed to the BSA as the basis for working out the earn out amount it was entitled to.

Decision

At first instance, the NSW Supreme Court ruled that while the BSA was clear, there was evidence that it did not set out the intentions of the parties at the time. The Court found that there was sufficient evidence to rectify the clause in the BSA so that it provided for the earn out to be paid on the basis of the annual average EBIT.

However, the Court of Appeal reversed this decision, finding that there was insufficient evidence to establish that the parties intended anything other than the position clearly set out in the BSA. Given the plain words used, the court was of the view that the buyer had a ‘heavy burden’ to prove some other common intention if it wanted the court to step in and rectify the BSA.

Pricing clauses

Earn outs are a useful mechanism for ensuring that the purchase price accurately reflects the value of a business – if earnings decrease after completion, an earn out allows the buyer to allocate some of this downside to the seller accordingly. However, as can be seen from this case, it is critically important that the deal documentation reflects the intended calculation of an earn out (and any other pricing mechanism the parties agree on). And this is why engaging an experienced M&A lawyer as early as possible in a transaction is always a good idea – we would say that , but we can’t tell you how many times we see buyers and sellers underestimating the importance of getting the legals correct!

Walter Baden has significant experience in advising both buyers and sellers on possible deal payment structures that are appropriate for the particular industry and target business. We also take care to understand the broader context of a deal and historic negotiations so that we can support our clients’ specific commercial drivers in a deal.