Earn-out clauses are progressively becoming a common feature of sale of business or company sale transactions. Earn-out clauses can be attractive to both the buyer and seller as they breach the gap in the sale price between the parties. However, there are various risks associated with earn-out clauses which may not be fully considered by the parties when entering into an agreement. Such risks include:

A. Tax Implication – it is important that the tax implications or consequences are taken into account by the parties when negotiating the mechanisms of the earn-out clause. The earn-out is generally considered as deferred consideration, however the seller may find itself with tax payment liabilities on entire gain upfront when the deferred consideration may not be due for some time. Subject to the tax amount payable, this could result in a cash flow issue for the seller.

B. Poor drafting, negotiations or mechanism of the earn-out – caution must be taken to ensure that the earn-out clause has been tailored to the particular circumstances and specific language has been used to avoid any ambiguity in the clause or potential differences in the interpretation of the clause.

The case of Lyam v Arthur J Gallaher Australasia Holdings is a reminder that poor drafting of the earn-out clause can lead to an unintended negative earn-out consideration. The court was hesitant to permit the parties to rely on pre-contractual negotiations when interpreting the terms of the earn-out clause.

C. Is the earn out to be calculated based on revenue or profit – if profit that may make it more subject to manipulation by the buyer and may necessitate more complex drafting to prevent that.

D. The changes that the buyer will introduce post completion to the running of the business may impact the performance of the business whilst the seller may not have the level of control to ensure adequate performance of the business.

E. Changes in economic conditions or the particular industry

To avoid these common issues, the parties need to be mindful of the following:

  1. The earn-out period;
  2. The mechanism and metric that will be used to calculate the earn-out;
  3. The mechanism that will be used to determine the business or corporation's performance;
  4. Part performance of the obligations under the earn-out clause;
  5. The difficulties meeting the targets set in the earn-out clause;
  6. The seller's continuous rights;
  7. Security for the earn out amount. E.g. A PPSR registration.
  8. Acceleration events, e.g. if the business is subsequently sold by the buyer or there is a change in control in the buyer's entity should that accelerate the earn out?
  9. Dispute resolution mechanism;
  10. Restrictions on the business or corporations during the earn-out period which could impact the earn-out; and

Whether the business will remain as a separate entity or be absorbed by the buyer's operating entity following the acquisition.

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.