Managing Your Cash Flow

How to manage earn-outs and avoid the grief of a dispute

7 min read

12 June 2012

There's been one often overlooked consequence of the economic crisis: an increase in the number of deals where earn-out agreements are used. This is essential because an earn-out bridges the gap between what the acquirer is prepared to pay and the seller expects to receive.

An earn-out links part of the purchase price to the performance of the business over a specified period after the acquisition has been completed. Difficulty in obtaining bank funding on acceptable terms and uncertainty about the future performance of the company being acquired means that buyers are keen to make sure that the consideration they pay is linked to the firm’s future financial performance.

The upside is that earn-outs (in theory) allow sellers to achieve a better price if the business performs well after the deal has been completed. The downside is that earn-outs often lead to serious disputes, with buyers arguing that reduced sums, or indeed no sums, are due under the agreement and sellers claiming that the financial performance of the company has been manipulated to avoid making payments to them.

With the pressure on all businesses to keep costs to a minimum and improve their financial position, disputes are becoming more frequent. It’s important that before agreeing to an earn-out, a seller understands that they may, in fact, never see a penny of the money promised.

So how can you reduce the chances of a dispute arising from an earn-out? Here are the five key areas that need to be covered to provide clarity for both sellers and buyers and minimise the risk of litigation:

Accounting policies

Be clear about the basis on which the post-deal accounts – on which the earn-out payment is based – will be prepared. Sellers will want to use the same accounting policies used pre-completion to ensure consistency and using the buyer’s policies, where these differ, may distort the sums due under the agreement. The problem here is that most buyers are keen for the company they have acquired to adopt accounting policies consistent with their own as soon as possible. A compromise is that two sets of accounts are prepared for the company for the earn-out period, one using the seller’s policies to calculate the earn-out payments and the other using the buyers’ policies to allow integration into the buyer group.

Calculation methodology

Make sure that the agreement is clear as to how the earn-out payment is to be calculated. Often payments are based on EBITDA (earnings before interest, taxes, depreciation and amortisation). This needs to be carefully defined with detailed provisions as to what is to be included or excluded. For example, is profit from the sale of a fixed asset, which would be a non trading profit, to be included or excluded? Similarly, should costs to the company incurred in relation to future revenues, that will not in fact appear until after the end of the earn-out period, be included or not?

Running of the company

Who will control the day-to-day operation of the company going forward? If the seller wants the business to go in one direction to maximise the earn-out payments, but the buyer has a different long-term strategy, how will that conflict be resolved? If the buyer has ultimate control, what protection is required for the seller to make sure the earn-out payments are not reduced?

Group issues

The buyer will have acquired the company with the intention of integrating it into its group structure. If inter-group trading is a possibility, are all transactions between the newly acquired company and other members of the buyer’s group to be conducted at arms length? Or will the newest member of the group receive an improved purchasing deal? If so, how should this be reflected in the earn-out calculations? Payment of dividends is another issue to consider. 

If the company makes profits, its parent may well wish to see these paid out as dividends, which may leave the company under-funded and unable to maximise its earn-out potential. On that basis, should there be an obligation on the new parent to fund the company to a specified level during the earn-out period in order to ensure that the earn-out provisions are not frustrated by keeping the company cash-strapped and unable to operate to its full potential?

Be specific

Often earn-outs contain obligations on the buyer to guarantee that the firm will be operated in the ordinary course of business with no significant changes being made during the earn-out period. Whilst it is difficult to draft an earn-out to cover every eventuality, general wording of this type is open to interpretation and causes many disputes. What one party perceives as a “significant change” may not be the same for another. Where possible, be specific. For example, if you want staff contracts to remain unchanged or an agreement that specific staff will be retained during the earn-out period – specify it. If the terms and conditions for key customers are not to be changed, spell it out. Make sure that all the key profit drivers are nailed down in the agreement to minimise conflict going forward.

It’s much better to argue about these issues at the time the deal is being done. Else you’ll end up in a dispute over earn-out payments too late, which can be a costly and stressful experience for all concerned.

Catherine Feechan is a partner in the corporate team of law firm Brodies LLP