Earn-out is that part of purchase price that buyers agree to pay to sellers in future based on future performance of the business. It can be linked to profitability or turnover or other parameters depending on the nature of the business.
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Earn-outs as a mechanism to bridge valuation gap
Earn-outs are often used in acquisitions when there is a substantial gap between valuation of buyer and seller. The gap can be bridged by structuring a payment at completion followed by one or more payments over a period of time based on the future performance of the business. Earn-outs would give a seller an opportunity to realise the future potentials of the business and synergy and expertise that a buyer will be bringing in. From buyers perspective that part of consideration is dependent on the future success of the business so a part of financial risk relating to the acquisition is covered in the event that the business fails to perform following the acquisition.
Earn-outs to ensure sellers future involvement
These future payments are often used when the seller’s continuous involvement in the business is important for the development of the business. In such circumstances as seller you do want to ensure that you are not prevented from being continuously involved in the business. As buyer you would want to ensure that the seller performs his duty and positively contributes to the future development of business and, if not, you have the ability to take action.
Risks and possible mitigation
Either as a seller or a buyer you need to be careful of the pitfalls this arrangement carries. As a buyer you would want to ensure that any earn-outs are determined by a measurable performance in the ordinary course of the business and at the same time structured in a way that gives them adequate flexibility to deal with uncertainties of future. As a seller you would want to ensure that any earn-out is maximised and performance is not artificially manipulated by a buyer.
There are various protections for sellers that can be built in the purchase and sale agreements depending on the nature of the business and the type of earn-out that the parties have agreed. It is important to consider ways in which the earn-out can be manipulated. However, buyers may not want to be restricted and may not offer all controls that sellers may ask for. If substantial part of the purchase price is structured as an earn-out then there is a considerable amount of risk involved for sellers due to elements that cannot be possibly controlled by either party.
Often restrictions to avoid profit manipulation are resisted by buyers not because they want to manipulate profits but they do restrict buyers from responding to business needs in ever changing commercial environment.
One approach is to structure earn-out based on number of units sold (if they are goods) or instructions received (if it is a service provision company). This approach may give certainty to sellers from price fluctuation and give adequate flexibility to the buyer to deal with group financial arrangements. However, they do need to be defined carefully to cover future change in trading pattern e.g. through a subsidiary or a sister concern.
Importance of heads of terms
To ensure clarity from the initial stage, it is advisable to enter into detailed heads of terms setting out commercial terms relating to earn-out as clearly and concisely as possible. Sellers should try and achieve a level of earn-out that is realistic to achieve and perhaps agree various thresholds triggering different levels of earn-out so they may be able to receive a lower amount if not the maximum. For example, a level of earn-out payment can be agreed for achieving 90% or 95% of the target rather than losing out on the entire earn-out payment if that target was only slightly missed.
Another issue that both sellers and buyers need to consider is the length of the earn-out period. In most cases this period is limited to 1 or 2 years following completion. However, we have seen it to stretch for a longer period.
Earn-outs do pose some complex commercial, legal and tax issues which parties should consider carefully before they agree the structure.
Gardner Leader Solicitors regularly advise buyers and sellers on the earn-out provisions contained in share or business and asset sale and purchases. To speak to one of our experts, please give us a call or visit our website.