An earn-out is a contractual tool in which part of the purchase price of a company is contingent upon its future performance, achieving specific milestones, or both. The structure of an earn-out varies based on the size and nature of the business, the parties’ expectations, the seller’s involvement post-acquisition, and how the acquired business will integrate with the buyer’s operations.
Due to their complexity and potential for disputes, earn-out arrangements require careful consideration. Legal, financial, tax, and accounting consultants should be involved early on, and the agreed terms must be clearly stated in the contract.
Why Use an Earn-Out
Earn-outs are typically used to bridge the gap in price expectations between the seller and buyer. They can also ensure the seller remains involved in the business for a certain period, aiding in knowledge transfer, ensuring a smooth transition, and retaining key personnel. They allow sellers to benefit from the company’s future success while enabling buyers to tie part of the price to actual performance. However, they present challenges, especially in determining the earn-out amount and balancing the seller’s interests with the buyer’s business strategies.
Earn-outs are particularly useful during times of market uncertainty, where business valuations are more complex, and risks and opportunities are harder to gauge, making it difficult to reconcile the differing views of buyer and seller.
Determining the Earn-Out Amount
Earn-outs are usually tied to financial metrics such as revenue, EBITDA, gross margin, or net income over a set period. To avoid disputes, it’s crucial that all parameters are clearly defined—using formulae, pro forma accounts, or example calculations—and that a mechanism for dispute resolution, such as an independent expert, is agreed upon. Non-financial targets, like securing regulatory approval, launching a product, or retaining key employees, may also be used.
Earn-Out Period
Typically, earn-outs span 1 to 3 years after the acquisition, though their duration depends on the parties’ objectives, risk tolerance, and the nature of the earn-out metrics. Factors such as the need for the seller’s continued involvement may also influence the length of the earn-out period.
Protection Mechanisms
Sellers often seek protections to ensure their earn-out, such as restrictions on how the buyer can manage the acquired business. Conversely, buyers want the freedom to integrate the business into their operations. Achieving a balance between protecting the seller’s earn-out and allowing the buyer operational flexibility is critical. A pre-agreed business plan might be used as a safeguard, with departures requiring mutual consent. Additionally, competition concerns must be taken into account when setting these restrictions.
If the seller stays with the company post-acquisition, the parties must agree on whether the seller forfeits the earn-out in certain situations, like termination due to misconduct (often referred to as “bad leaver” clauses). These clauses are contentious and add complexity to the arrangement.
Tax Considerations
Earn-outs can trigger tax implications, so it’s essential to consider these from the start. For sellers involved with the company post-sale as employees or directors, there is a risk that the tax authority may treat the earn-out as salary income rather than capital gains, leading to higher taxes.
Anti-Embarrassment Clause
Sellers may request an anti-embarrassment clause, which guarantees earn-out payment even if the buyer sells the company to a third party during the earn-out period. This protects the seller from being seen as selling the business at an undervalued price and prevents negotiations with the new buyer over earn-out terms.
Security
To safeguard the earn-out payment, especially when the buyer uses an acquisition vehicle, security mechanisms such as escrow accounts or guarantees may be established. Additionally, the buyer might seek the right to offset any claims against the seller against the earn-out amount to protect against potential damages.