This blog has previously provided an overview of how blockchain technology and smart contracts might be adapted to the legal industry. In this post, we will explore the specific example of how these technologies may be able to simplify an earn-out agreement in an M&A transaction.
What are earn-outs?
In an earn-out, the seller of a business receives additional compensation after closing if the business meets certain financial goals. To put it simply, an earn-out is a series of “if-then” statements that determine how much the seller is paid based on different factors.
How smart contracts may help
Inherent in the traditional earn-out contract is a significant counter-party risk. This risk is manifested by the need for each party to trust that the other will behave according to the rules of the contract. One way to address this trust deficit is to build the conditions of the earn-out into a smart contract so that the seller is automatically paid in accordance with the rules of the contract if certain conditions are met.
This has certain advantages over the traditional earn-out contract. Most notably, the smart contract can be objective and automatic. For example, consider an earn-out that pays the seller a percentage of gross revenues earned by the business. The smart contract could be programmed to draw the gross revenue data from the company’s bank account or payment processor and then automatically pay the correct amount to the seller on a fixed schedule. An almost unlimited number of variations of this could also be built into a smart contract to cover more complex scenarios.
Shortfalls of smart contracts
Despite its advantages, using a smart contract for an earn-out does have certain shortfalls. One of the most common criticisms of smart contracts is that they are only as “smart” as the data they receive. Additionally, there are some forms of data that are not amenable to being objectively gathered for use in a smart contract. For example, if an earn-out was to be paid from a business that did most of its sales in cash, there might not be an objective input for the smart contract and the seller would need to trust that the counterparty was including all of the cash sales in the earn-out calculation. Other subjective forms of data, such as when to recognize revenue, could also make using a smart contract more difficult.
That said, as smart contract technology continues to develop and more business is done digitally, there may be opportunities to address some of these shortfalls such that smart contracts can be used not only in earn-outs, but in a wide range of legal contracts.
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