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Validity of an earn out notice

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29/01/2014

The negotiation of earn out provisions is often one of the pinch points in the negotiation of a share purchase agreement. The preparation and service of the earn out notice tends to attract less attention. This can be costly as a recent High Court judgment demonstrates.

In Barratt v Treatt plc [1] a share purchase agreement (the SPA) provided for an earn out to be calculated by reference to the pre-tax profits of the target group as shown in the audited accounts. The agreement also required the purchaser to carry out the initial calculation of the earn out and to provide notice of that calculation to the seller. Failure to do so by the purchaser would result in the calculation of the earn out being referred to an independent accountant for determination.

The purchaser duly served notice of its earn out calculation on the sellers. However, it was apparent from the notice that the calculation had been determined, at least in part, by reference to management accounts rather than the audited accounts as required by the SPA. The seller sought a declaration that the notice was invalid.

In arguing that the earn out notice was valid, the purchaser sought to draw a distinction between the contractual requirements regarding the validity of the earn out notice and the contractual requirements regarding the calculation of the earn out. It was, the purchaser maintained, possible for an earn out notice to be valid, so long as it set out the basis of the calculation in reasonable detail (as required by the SPA), even though the figure specified did not conform to the requirements of how the earn out was to be calculated.

The High Court declared the earn out notice to be invalid. The definition of the earn out was of central importance to the parties and admitted of no leeway to the parties as to its calculation. The clause requiring delivery of the earn out notice must be construed as meaning delivery of a notice including a calculation of the earn out on the sole basis permitted in the SPA. The fact that the calculation was based on management accounts as opposed to the audited accounts meant that it did not conform to the requirements of the SPA and, as such, was fatally flawed.

Consequently, the purchaser had not complied with the timescales set out in the SPA for serving an earn out notice, with the result that the determination must be submitted to an accountant, as stipulated in the SPA.

Walker Morris comment
Parties will usually ensure that they comply with the provisions of an SPA regarding method of serving notice and doing so within the specified timescales. This case is a reminder of the need to ensure that the content of the notice must also be correct or else the notice runs the risk of being declared invalid.

[1] [2013] EWHC 3561

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