First of all, what is an earn-out? It’s that part of the purchase price that buyers agree to pay to sellers based on the future performance of the business. It can be linked to profitability or turnover or other parameters depending on the nature of your business.
It bridges the valuation gap
An earn-out is 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 time based on the future performance of the business. Earn-outs give you an opportunity to realise the future potentials of the business, synergy and expertise that a buyer will bring.
From a buyer’s perspective, a part of the purchase price will depend on the future success of the business following the acquisition. Therefore, a part of financial risk relating to the acquisition is mitigated by non-payment of full purchase price if the business fails to perform following the acquisition.
Ensures sellers future involvement
If you are important for the development of the company following the sale, then a buyer may use an earn-out to incentivise your involvement in future. For many owner managed businesses this a good way to plan their retirement. In such circumstances, ensure that you’re not prevented from being continuously involved in the business. On the other hand, a buyer will want you to perform your duties and positively contribute to the future development of the business and, if not, given the ability to act.
Risks and possible mitigation
Both buyers and sellers need to be careful of the pitfalls this arrangement carries. As a buyer, ensure any earn-out is determined by a measurable performance in the ordinary course of the business and at the same time structured in a way that gives adequate flexibility to deal with uncertainties in the future. As a seller, check the earn-out is maximised and performance is not artificially manipulated by a buyer.
There are various protections that can be built in to the purchase and sale agreements depending on the nature of the business and the type of earn-out the parties have agreed. It’s important to consider ways in which the earn-out can be manipulated. For example, profit can be manipulated by group arrangements such as management charges. Often restrictions to avoid profit manipulation are resisted by buyers, not because they want to manipulate profits but because they restrict buyers from responding to business needs.
If a substantial part of the purchase price is structured as an earn-out, then there is a considerable amount of risk involved for you as a seller due to elements that cannot be possibly controlled by either party.
Basis of earn-outs
One approach is to structure an earn-out based on number of units sold (if they are goods) or instructions received (if it is a service provision company). This may give you some certainty 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.
Level of earn-outs
You should try and achieve a level of earn-out that is realistic and perhaps agree various thresholds triggering different levels of earn-out. This will enable you to receive a lower amount, if not the maximum. For example, a level of earn-out payment can be agreed for achieving 90 per cent or 95 per cent of the target rather than losing out on the entire earn-out payment if that target was only slightly missed.
Length of earn-out period
Another issue that you need to consider is the length of the earn-out period. In most cases this period is limited to one or two years following completion. However, we have seen it stretched for a longer period but there is increased level of risk and uncertainty in such arrangement.
No matter what you agree with the buyer, it’s important to ensure clarity from the initial stage. Enter into detailed heads of terms setting out commercial terms relating to the earn-out as clearly and concisely as possible. Earn-outs do pose some complex commercial, legal and tax issues which parties should consider carefully before agreeing the structure.
Ami Bhatt is associate in the commercial team at Gardner Leader solicitors
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