We often see earn out provisions being proposed as part of an M&A transaction and there are a number of reasons for this, so we thought it would be useful to identify some of the key considerations to keep in mind when dealing with such a situation. An earn out can be attractive to both the seller and buyer, as it can provide the seller with the opportunity to potentially achieve a higher sale price, while providing comfort to the buyer that it will only pay for what is achieved.
What is an Earn Out?
An earn out clause provides a mechanism for payment of part of the purchase price after completion, conditional on or calculated by reference to financial performance or the happening of an event after completion.
As mentioned above, there may be a number of reasons for the inclusion of an earn out in an M&A transaction, including:
- the purchase price may have been arrived at based on an earnings forecast prepared by the seller or the seller has made statements about events to occur after completion. In these situations an earn out gives the buyer the ability to retain some of the purchase price if these forecasts are not met or the events do not occur. Furthermore, the parties do not need to negotiate about warranties being given about these forecasts or events, and such warranties are usually not given or if they are given, they are caveated; or
- if the seller remains in the company or business in some director or management capacity, an earn out is an incentive to those persons to ensure that any forecasts are met or events do occur.
Performance Hurdles – What are appropriate?
If an earn out is to be used in an M&A transaction then consideration needs to be given to the performance hurdles to ensure they align with the earn out. As indicated above, the performance hurdles could be financial or non-financial.
- a performance hurdle based on EBITDA would be suitable for a company or business where the revenue is closely tied to the use of capital assets; alternatively
- parties may wish to have a performance hurdle based on a non-financial event, such as securing a key contract or bringing a new product to market.
The selection of a performance hurdle needs to occur on a case by case basis and must address bridging the 'valuation' gap between the seller and buyer. Furthermore, if the performance hurdles in an earn out clause are not drafted correctly, it could result in tax on the entire purchase price (including the potential earn out amount) being paid upfront and also stamp duty being assessed on that entire amount, even though the earn out amount may ultimately not be paid.
What can contribute to a Performance Hurdle not being satisfied?
There are a number of reasons why performance hurdles may not be satisfied; however, if the parties have given appropriate consideration to them during the negotiation and drafting of the agreement then the risk of disappointment can be mitigated.
Below are some of the key points that need to be considered when negotiating and drafting an earn out clause:
- sale/change of control of the company or business during the earn out period: When acting for a seller, we recommend that the earn out clause is drafted so that the earn out amount is paid out in full upon such an event;
- time period for an earn out: The parties need to carefully consider what time period should be applied to an earn out (e.g. a short time period may not help show the long term prospects of the company or business, whereas a long time period may delay full integration and increases the risk of non-satisfaction of the performance hurdles);
- increase/allocation of expenses: The agreement needs to clearly address the mechanism for applying the allocation of expenses (e.g group insurance, additional administration resources, fees charged in accordance with intergroup practices, R&D, marketing etc.) and how they are calculated in relation to the earn out, as otherwise a dispute will likely arise, especially if your performance hurdle is financial in nature;
- accounting principles: The parties need to agree and document (right down to specific line items) the accounting treatment that is to be used, so as to ensure there is no likely discrepancy;
- investment: Consideration needs to be given as to whether the company or business requires investment to satisfy the performance hurdle and what happens if such investment does not occur; and
- seller agreeing to an unrealistic performance hurdle: This situation will always likely end in disappointment and potential dispute, which are both an issue for the seller and buyer, hence why it is important to align both the performance hurdle and earn out.
When considering an earn out, a general starting position is that the seller must be satisfied with the purchase price that they receive on completion and must view the potential earn out as an added benefit – if it materialises.
Parties, particularly sellers, to an M&A transaction and their advisors need to remember that a seller goes from controlling every aspect of a company or business to (at best) simply running it at the direction of others. Many earn outs end in disappointment and dispute, but this can be alleviated provided the parties spend the necessary time to properly negotiate and draft an earn out clause that clearly sets out the performance hurdles and addresses the key areas which may result in dispute.
We would be happy to discuss any potential earn out scenarios with you, so as to help avoid disappointment and dispute, and to achieve an effective alignment of the interest of the parties following completion.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.