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When buying/selling a business, it is always important to consider what mechanism is best suited for the purchase price.
The parties will consider whether the purchase price should be made in full at the time of completion of the purchase/sale or partly on completion and partly contingent on the business's future performance.
What is an earn out provision?
An earn-out provision is a pricing mechanism whereby an element of the purchase price in a purchase agreement is contingent on the company's future performance.
Earn-out provisions are more commonly utilised when dealing with mergers and acquisitions; in particular, they are more common in share purchase agreements.
An earn-out provisions is essentially used to bridge valuation gaps between the buyer and seller and is often used in high-growth businesses where the business today may be worth a certain figure but in the future should be worth more.
An earn-out provision can also act as a management incentive where owner-managed businesses are sold, and the managers continue to work for the target for an agreed period following the sale.
Why is an earn-out provision important?
Usually, an earn out clause is preferred by the buyer; however, there are some advantages to both parties in a transaction:
The advantages for the buyer
The buyer can retain the expertise of the seller(s) in the company after buying the business. In addition, the buyer will also be able to defer part of the purchase price to a date in the future.
An earn-out provision also encourages the seller to remain in the business following completion and attempt to make the business a success.
The disadvantages for the buyer
The parties may have conflicting interests, as the seller(s) will want to maximise the purchase price, whereas the buyer may want to keep the purchase price at a lower level.
The seller(s) will also want to ensure that the buyer does not do anything that restricts the business's growth and thus restricts their ability to hit the earn out targets, which can lead to a difficult relationship between the parties.
The advantages for the seller
Depending on the terms of the earn out, it allows a seller to benefit from a positive development of the company, as an earn out will usually be contingent on the positive performance of the company.
The earn out could also allow the seller to benefit from synergies in the buyer's group, potentially leading to the seller maximising returns.
The disadvantages for the seller
An earn-out clause will bring uncertainty to a seller as a portion of the purchase price will be subject to the company achieving a certain objective/target.
It may also be the case that a particular market suffers from outside factors outside of the seller's control (e.g. the covid-19 outbreak).
Practical considerations for an earn-out
- A suitable metric to measure growth or the parts that matter to both seller(s) and buyer needs to be found.
- Earn out protections need to be negotiated.
- Usually, the seller would remain a business director during the earn out clause's lifespan.
- The earn out should be drafted to factor in the possibility of disputes in the sum of the earn-out, and it is appropriate to factor into the drafting the appointment of an expert to settle any dispute between the parties.
- Usually, following completion of the transaction, the buyer will pay stamp duty on the maximum amount of the potential earn-out, even if the seller still needs to achieve the targets set out in the earn-out.