What is an earn-out?
The term ‘earn-out’ is used to describe an agreement between the buyer and seller of a Target Company whereby at least part of the consideration is determined by reference to future profitability of the Target Company for a specified period after completion.
Typically, the arrangement would be structured so that part of the purchase price will be paid on completion, followed by a further payment or series of payments depending on the profits made by the Target Company.
Why use an earn-out?
Earn-out arrangements are often used when the sellers continue to manage the Target Company after completion.
They are also used where the buyer and seller cannot agree on the value of the Target Company at completion, for example, if they have differing views on the future prospects and profitability.
Advantages of an earn-out
An earn-out can have advantages for both the buyer and the seller.
From the seller’s perspective:
· They may be able to have the full benefit of selling a profitable business and not have to discount the purchase price as result of the buyer doubting the value of Target Company.
· They can participate and contribute to future growth of the Target Company.
From the buyer’s perspective:
· They can ensure a more accurate valuation of the Target Company and protect against overpaying and uncertainty.
· Deferring part of the purchase price can have cash flow benefits and reduces the buyer’s reliance on being granted a loan.
· The sellers will be motivated to stay on in the Target Company and maximise profitability and performance, which may also assist client transition and retention.
Disadvantages of an earn-out
Although using an earn-out arrangement can help to move a transaction forward, they also create the potential for future disputes.
For example, earn-outs prevent the seller from achieving a clean break from the Target Company, meaning they will potentially retain a day-to-day involvement in the business.
Also, the buyer may be pulling in different directions to the seller as the latter will want to maximise profit during the earn-out period and the buyer will want to make decisions to benefit the Target Company in the long-term.
When deciding on an earn-out arrangement, both parties need to carefully consider:
· The extent which the sellers retain control of the business after completion.
· The length, timing and structure of the earn-out period.
· The definition and method for calculation of ‘profit’.
· Whether there will be restrictions on Target Company’s activities during the period that could negatively impact on the earn-out.
· The seller’s eventual departure from the business and whether to include ‘good leaver’ and ‘bad leaver’ provisions.
While earn-outs are useful to bridge valuation differences, as highlighted above, these arrangements can come with complications. To minimise the risk of problems arising, it is essential that both parties seek advice to ensure the earn-out arrangement is well structured and has protections for both the seller and buyer.