This week we’re looking at earn-outs, how they can be a useful tool for bridging the difference between a seller’s and a buyer’s view on value, some of the issues that need to be addressed when negotiating them, how to protect yourself and give yourself the best chance of achieving it.
It is often the case that a seller’s view on a company’s value differs from that of a buyer. Whilst both parties may be agree on the level of the past and current performance of a business, it is common for a seller to have a more optimistic view of the company’s forecast turnover and profits.
Meanwhile, a buyer may be uncomfortable about paying for future performance before that performance has been proven.
An earn-out is a mechanism where, in addition to any sums paid on completion, a seller is paid further consideration after a deal has closed. This additional consideration is calculated based on agreed measures of performance post-completion. These performance measures are usually financial in nature (e.g. turnover, EBITDA etc…) can be spread over any time period between less than one year and five years.
So far so simple… however, there are a number of issues to bear in mind when agreeing to an earn-out when selling your company:
First, unless the amount you are being paid on completion is sufficiently large in itself, then you need, of course, to be comfortable that the future performance targets are achievable. If not, then you may never receive any earn-out payments.
Second, it is important that the business is ring fenced and protected sufficiently so that any factors out of its (or your) control do not adversely affect the ability to make the earn-out. Examples of these would include performance of the buyer’s wider group, or costs that are laden on your business post completion.
There will inevitably be a tension here with a buyer’s desire to extract maximum synergies by combining the two businesses so as to achieve as much benefit as possible from the deal. This becomes particularly acute if you stand to benefit from some of these synergies as well – for example, if the buyer is promising you lots of cross-selling opportunities. In practice, it’s relatively rare for these synergies to have a material impact on your earn-out, especially if it’s a short one. In most cases, you will be better off ensuring you’re protected, rather than being seduced by promises of future benefits from the buyer.
Third, the business should have sufficient funding and key people must have enough time focussed on the business to enable it to achieve the earn-out targets.
Fourth, the earn-out should be structured in such a way that earn-out payments are taxed as capital rather than as income – a poorly structured earn-out can easily fall into this trap, especially if a purchaser tries to make it contingent on key people remaining with the company for the earn-out period.
Finally, remember that the people you’re negotiating with now may not be the people you deal with when the earn-out is finally calculated and paid. People move on, or up, or out, and a new counterparty won’t necessarily remember the promises that were made to you unless they’re properly documented and unambiguous.
So the devil here really is in the detail – a well-negotiated earn-out is a valuable mechanism but one that is poorly put together may not deliver what it should.