The inclusion of an earn-out clause in a purchase agreement can be a useful tool to help bridge the valuation gap between buyer and seller. Broadly speaking, an earn-out ties a portion of the purchase price to the performance of the business following the acquisition, which the seller can "earn" by meeting post-closing performance targets. According to the American Bar Association's 2014 Canadian Private Target Mergers & Acquisitions Deal Points Study (the 2014 ABA Study), earn-out clauses were present in 25% of the transactions surveyed, a slight increase from 21% in the American Bar Association's 2012 study and a significant increase from 3% in its 2010 study.
Acting as a form of acquisition currency, a well-crafted earn-out clause can be attractive to both the buyer and seller. It provides the seller the opportunity to potentially achieve a higher sale price, while providing comfort to the buyer that it will only pay for the seller's provable or safe earnings on closing. Payment for riskier (or growth) earnings is put off until such earnings are confirmed through the post-closing performance of the business. This can be especially attractive where the seller is a company with a limited track record.
A successful earn-out clause provides a clear and well-understood purchase price adjustment mechanism that aligns the interests of the buyer and seller. The following five questions highlight some of the key considerations that buyers and sellers alike should keep in mind when conceiving, negotiating and drafting an earn-out clause:
1. What is the appropriate performance metric?
Choosing performance metrics that will align the incentives of the parties is one of the most important steps of structuring an earn-out. In some cases, focusing on a non-financial earn-out metric such as key customer retention, bringing a product to market or securing a key patent might make more sense than using a financial metric. In other cases, the parties may have a more financial focus and prefer to base the earn-out calculation on financial metrics, ranging from top line revenue to an earnings based metric, most commonly EBITDA. Sellers will often prefer to use a revenue-based financial metric, as these tend to be the easiest to calculate and harder to manipulate than metrics further down the income statement. Buyers, by contrast, will tend to prefer an earnings-based metric, which is usually a more accurate indicator of the business' economic potential. In some cases, the parties find balance and benefit in using multiple metrics, though this can come at the cost of increased complexity. In the 2014 ABA Study, 12% of Earn-out clauses used revenue as a metric, 33% used an earnings based metric and while 53% used some other (including non-financial) form of metric.
2. Is the involvement of the seller needed to transition the business post-closing?
There can be real value in keeping the seller involved in the business post-closing, particularly if the seller has unique technical or operational expertise or strong customer relationships that need to be transitioned. An earn-out clause provides an excellent incentive for sellers to remain engaged and motivated during the transition period, particularly when their efforts will can reasonably be expected to have a real effect on the post-closing success of the business. In other circumstances, a clean break may be desired, with little to no seller involvement post-closing. Particularly in these cases, it is not uncommon for the seller to seek added contractual protections on the post-closing conduct of the business.
3. How should the business be run post-closing?
After closing, the buyer will usually want the flexibility to run the business as it sees fit, which may include changing strategic direction if the business environment so requires. The seller, by contrast, generally wants some assurance that the business will be managed in a manner conducive to achieving the earn-out targets and will seek to limit the new ownership's ability to make changes that could frustrate this goal. The parties must decide, in the context of their transaction, whether and the extent to which contractual covenants relating to the post-closing conduct of business are appropriate. For example, at least 20% of the earn-out clauses examined in the 2014 ABA Study included a covenant to run the business consistently with past practice. Sellers may also seek out a covenant to run the business in a manner to maximize the earn-out, though as noted in the 2014 ABA Study, express provisions of this nature are relatively uncommon. On the opposite end of the spectrum, a buyer may seek to expressly disclaim a fiduciary relationship with respect to the earn-out. Following the Supreme Court's ruling in Bhasin v. Hrynew, which opens the possibility of an implied general good faith obligation being read into the performance of a contract in the absence of specific language, buyers and sellers may be increasingly interested in taking the time to clearly spell out what the obligations of the parties are and are not intended to be over the earn-out period.
4. What is the appropriate time period for an earn-out?
The parties will want to carefully consider the appropriate period of time over which to evaluate the earn-out. Too short an earn-out period can incentivise short term behaviour (particularly if the seller stays involved in the business), and may not be indicative of the longer term prospects of the company. Too long of an earn-out period can unnecessarily delay full integration of the business and increases the earn-out risk to the seller. A one to three year earn-out period is most common in the context of Canadian M&A transactions, but earn-out periods of four years or longer were used in 20% of the deals containing earn-out clauses in the 2014 ABA Study.
5. What happens if the future is different than predicted?
Even if the parties have similar expectations at the time of the bargain, the future is never easy to predict. Accordingly, the parties may wish to consider including provisions that provide for the "buy-out" or acceleration of an earn-out under certain circumstances. For instance, if a buyer believes that there is a chance that it may want to re-sell the business before the end of an earn-out period, it may be beneficial to negotiate in advance the ability to accelerate or "buy-out" the earn-out in order to make the business more attractive to a future purchaser who may otherwise be discouraged from acquiring assets encumbered by an earn-out. Where the parties have covenanted to manage the business consistently with past practice or in some other pre-specified manner, the ability to "buy-out" an earn-out may provide valuable flexibility for the buyer to change strategic direction or fold the target company into its existing business should it become commercially beneficial to do. From the seller's perspective, an acceleration or early payment provision may help protect against post-closing changes to the business that hinder the likelihood achieving the earn-out. For example, an acceleration clause trigger could be the termination of key members of the management team or a significant change in the manner of the operation of the business. In the 2014 ABA Study, 7% of transactions containing an earn-out clause contained an express acceleration clause.
While earn-out clauses may not be appropriate in all transactional contexts, they remain a useful situational tool when crafted appropriately. Diligent and careful negotiations are necessary to resolve the stress points between the parties to reach an agreement that will hold together after closing and to ensure that incentives are optimally aligned for the benefit of both buyer and seller.
The author would like to thank Matthew Lau, articling student, for his assistance in preparing this legal update.
Norton Rose Fulbright Canada LLP
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