Canada: Structuring Earn-Outs In M&A Transactions

Last Updated: May 2 2017
Article by Al Wiens and Troy Pocaluyko

Introduction

In the context of merger and acquisition (M&A) transactions, buyers and sellers are always looking for ways to ensure that they each receive full value. Generally, sellers are asked to make certain representations about the status of the target business from which buyers determine the prospects of the business they are acquiring. An inventive way that the parties to M&A transactions have come up with to try to mitigate the risks the buyer is taking on, including to ensure that the purchased business continues to generate the revenues the buyer is expecting, while at the same time providing the compensation that the seller believes is fair, is through the mechanism of an "earn-out" provision in the purchase and sale agreement.

What is an Earn-Out?

An earn-out is a negotiated payment arrangement over time between a buyer and seller. The seller agrees to receive at least part of the purchase price in the form of one or more contingent payments following closing (i.e., after the date on which the sale is completed and the buyer takes possession of the purchased business). The quantum and timing of the deferred payments are usually determined by reference to certain performance or operational benchmarks of the target company or the combined company over a period of time after closing. In other words, an earn-out is a type of contingent payment payable only upon the attainment of certain pre-defined parameters, such as specified EBITDA or revenue targets.

An earn-out should not be confused with and is not the same as a purchase price adjustment, which is often based on historical parameters as reflected in the target's financial statements as of the closing date of the transaction. In an earn-out arrangement, the seller generally (but not always) continues to work in the business following closing and therefore has a direct influence on the performance of the business. If it performs as expected, the seller will receive one or more payments at a predetermined time, which payments represent the deferred portion of the sale price of the business.

The amount and timing of the earn-out payment(s) to be received can be as creative as the parties desire (assuming there is agreement on the concept of the deferred payment, to begin with); earn-outs can be based on revenue targets or growth targets, they can be paid periodically or on a one-time basis, they can be as small or large of a percentage of the sale price as the parties might agree. The payments can be made out of cash flows or out of the general resources of the buyer; the amount can be held in escrow or represent a secured or unsecured obligation of the buyer. In addition, the involvement of the seller in the business post-closing can be either significant or fairly transparent to anyone dealing with the business after closing. Consequently, with no set structure, earn-outs, if they are agreed to at all, tend to be heavily negotiated.

A "reverse earn-out" is a variation on the concept. Under this arrangement, instead of receiving an earn-out payment based on a positive multiple or percentage of the performance target, the seller will receive the entire purchase price at closing (whether in the form of cash, promissory note or a combination of both), but will need to return/reimburse a certain amount of money (or reduce/set-off any indebtedness owed by the buyer) if the performance target is not achieved. In other words, the seller in a normal earn-out arrangement will work hard to earn the additional amount, whereas the seller in a reverse earn-out arrangement will strive to avoid paying the amount back.

Purpose and Pros & Cons

In a variety of situations, an earn-out arrangement can help the parties bridge the gap in their respective expectations in order to complete a sale. In a typical earn-out scenario, a seller may be optimistic that its business has great growth potential, while the buyer may not be convinced that the projected results will materialize and may be more reserved about paying in advance an enhanced purchase price which assumes that the target business will achieve those projected results. In these situations, an earn-out feature could be structured to close the deal and to alleviate the concerns of the buyer.

From the buyer's perspective, an earn-out agreement may be beneficial because:

  • it allows the buyer to reduce its initial investment by deferring payment of part of the purchase price and preserve cash or availability under its credit facilities;
  • it helps the buyer to avoid overpaying;
  • it allows the buyer to reduce leverage, which can be helpful in a tight credit market where the cost of capital is high;
  • it motivates the seller to stay on during the transition and earn-out period to ensure performance targets are met; and
  • it allows the buyer to potentially offer a higher bid in an auction process because it does not have to pay the full price at closing.

From the seller's perspective, an earn-out agreement may be beneficial because:

  • the seller may be able to receive a higher offer from the buyer;
  • it may enable the seller to allocate the incremental purchase price among those shareholders who remain involved in the business following closing; and
  • the seller may benefit from a synergy created by the transaction, which may give the seller an upside on the earn-out payments.

However, an earn-out agreement can also have disadvantages. It can be difficult to negotiate and requires careful consideration as to the future conduct of the business and extensive accounting analysis, which can lead to additional cost. It also requires monitoring and periodic evaluation of the target's performance after closing. Further, even when the target business does meet the performance target, disputes may arise as to how the earn-out payments should be calculated. Moreover, the seller may not wish to remain involved in the business, either due to disinterest or because the seller has commitments to a different venture. An earn-out can also pose risks to the seller. In situations where the seller does not remain involved in the target business following closing, it becomes vulnerable to the actions of the buyer. In the worst-case scenario, where the target does not meet the performance target, the seller would not receive any payments on account of the earn-out.

Structure

The earn-out provisions in a purchase and sale agreement must be tailored to the needs and expectations of the parties. It is not a one-size-fits-all solution, and certainly not a magic bullet to conclude an agreement. Careful analysis and negotiations are required to structure an earn-out agreement that will suit the business needs of the parties. Several issues should be addressed in an earn-out agreement, including the following:

  • Appropriate performance criteria or targets – These can be either financial metrics (i.e., net revenues, gross margin, net operating income, EBITDA, EBIT or EBT) or operational or project-based (e.g. the completion of a research project, implementing a production line or facility online, or closing of a specific sale).
  • Duration of the earn-out period – Earn-out periods typically last between one to three years, although they can be for whatever period the parties mutually agree.
  • Payment structure – Payments usually become due and payable at the end of the earn-out period, or at intervals during the earn-out period, when the performance targets have been satisfied or partially satisfied. The amount of the earn-out payments can take several forms, such as a flat amount, a percentage of the earn-out target, a multiple of the amount exceeding the performance target, or any other pre-defined formula. The earn-out payments can be made either in cash or stock. However, when the payments are made using the buyer's shares, they may trigger additional valuation requirements and securities laws considerations.
  • Method of evaluation – To avoid disputes in determining whether performance targets have been met, earn-out provisions should include detailed procedures governing how to measure the performance. For instance, the parties may consider setting out the specific accounting principles and adjustments that are to be applied in preparing the financial statements and provide the seller with sufficient time to review them.
  • Impact of extraordinary events – What happens if (in particular, should payment of any remaining earn-out amounts be accelerated), for example:
  • the buyer terminates the employment of the seller (assuming he or she stayed on with the business post-closing and agreed to an earn-out in part because he or she would have significant input on the direction and day-to-day operations of the business during the earn-out period);
  • the buyer sells the business during the earn-out period (the seller may have agreed to the earn-out on the basis that he or she had confidence in the buyer's ability to run the business –but not necessarily a third party who is unknown to the seller); or
  • the buyer wants to merge the business with some other business, in which case the "earn-out metrics" may no longer be independently measurable.

    • Future conduct of the business – The parties should consider whether there is any obligation on the buyer to operate the business post-closing in a manner that is intended to maximize the earn-out or if the buyer is free to run the business as it sees fit. Alternatively, the earn-out could be set up such that the buyer cannot take certain actions that might make sense for the business in the long term but adversely impact the earn-out in the short term (e.g., incurring additional capital expenditures or discontinuing a key product line). In any event, this is a key issue when negotiating an earn-out that can be a source of significant tension between the parties, so it should be addressed early on in the structuring discussions.
    • Security (if any) for the earn-out payment – Whether the buyer should be required to pledge the shares or assets of the business to the seller or post some other form of security in the event that the buyer fails to satisfy the earn-out payment.
    • Seller's involvement in the business post-closing – Quite apart from any other considerations, the buyer might need the seller's expertise, connections or reputation in order to operate the business in the normal course following closing.
    • Dispute resolution mechanism – For example, the involvement of an independent accountant if there is disagreement regarding whether the earn-out metrics have been achieved.

Tax Considerations

From a tax perspective, in the context of a share sale, the earn-out payments will effectively be treated on capital account (in the year that such amounts become determinable) provided that such earn-out payments meet the criteria to apply the "cost recovery method" as enumerated by the Canada Revenue Agency. In general, this criterion only applies in the context of a share (and not an asset) sale and requires, amongst other things, that the earn-out arrangement arises due to difficulties in valuing the underlying goodwill of the business (and not for other reasons). As such, many share sales (and all asset sales) will not meet such criteria, in which case, there is a risk that such earn-out payments will be treated as regular income. 

In circumstances where the cost recovery method is not available, a vendor may wish to consider a reverse earn-out. Under a reverse earn-out, the purchase price is set at the maximum possible amount and, provided certain criteria are satisfied, the vendor will generally treat the entire amount on capital account in the year of sale (subject to the availability of a reserve).    Moreover, if in a subsequent year the relevant performance criteria are not satisfied (such that a portion of the purchase price must be repaid), the vendor will generally adjust its applicable proceeds of disposition and/or claim a capital loss (and offset such capital loss against its proceeds realized in the earlier year). However, it should be noted that there are a number of complexities involved in structuring a reverse earn-out and whether a reverse earn-out will be beneficial to a particular vendor does depend upon a number of factors including the nature of the assets being sold and the length of the earn-out arrangement.     

Summary

When structured properly, earn-out agreements can be very useful in bridging the valuation gap between the parties who may otherwise abandon the deal. They could also lead to a win-win situation in that the buyer is protected from the downside risk and the seller potentially can realize a higher price for its business than would otherwise be possible.

However, there are risks posed by such arrangements and potential disputes that can arise. Parties must be diligent in making sure that key issues are addressed in detail in the earn-out provisions of a purchase and sale agreement and that the parties' needs and expectations are properly reflected in the agreement.

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.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Troy Pocaluyko
 
In association with
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.