Earn-out is that part of purchase price that buyers agree to pay to sellers in future based on future performance of the business. It can be linked to profitability or turnover or other parameters depending on the nature of the business.
Earn-outs are often used in acquisitions when there is a substantial gap between valuation of buyer and seller. The gap can be bridged by structuring a payment at completion followed by one or more payments over a period of time based on the future performance of the business. Earn-outs would give a seller an opportunity to realise the future potentials of the business and synergy and expertise that a buyer will be bringing in. From buyers perspective that part of consideration is dependent on the future success of the business so a part of financial acquisition risk relating to the acquisition is covered in the event the business fails to perform following the acquisition.
However, either as a seller or a buyer you need to be careful of the pitfalls this arrangement carries. As a buyer you would want to ensure that any earn-outs are determined by a measurable performance in the ordinary course of the business and giving them adequate flexibility to deal with uncertainty of future. As a seller you would want to ensure that any earn-out is maximised and performance is not artificially manipulated by a buyer.
These future payments are often used when the seller’s continuous involvement in the business is important for the development of the business. In such circumstances as seller you do want to ensure that you are not prevented from being continuously involved in the business. As buyer you would want to ensure that the seller performs his duty and positively contributes to the future development of business and, if not, you have the ability to take action.
There are various protections for sellers that can be built in the purchase and sale agreements depending on the nature of the business and the type of earn-out that the parties have agreed. It is important to consider ways in which the earn-out can be manipulated. However, buyers may not want to be restricted and may not offer all controls that sellers may ask for. If substantial part of the purchase price is structured as an earn-out then there is a considerable amount of risk involved for sellers due to elements that cannot be possibly controlled by either party.
To ensure clarity from the initial stage, it is advisable to enter into detailed heads of terms setting out commercial terms relating to earn-out as clearly and concisely as possible. Sellers should try and achieve a levels of earn-out that is realistic to achieve and may be agree various thresholds triggering different levels of earn-out so they may be able to receive a lower amount if not the maximum.
Earn-outs do pose some complex commercial, legal and tax issues which parties should consider carefully before they agree the structure.