Earn outs as part of the overall consideration for transactions

March 2019  |  SPOTLIGHT  |  MERGERS & ACQUISITIONS

Financier Worldwide Magazine

March 2019 Issue


An earn out is a mechanism commonly used in acquisitions, under which part of the purchase price is deferred and made attributable to the future performance of the target’s business after completion. The mechanism is popular with buyers because it apportions some of the risk of the future performance of the business between the seller and the buyer. It can also be an attractive proposition to incentivise sellers in transactions where they are to remain involved in some capacity following completion.

Earn outs can be used in all types of transactions, but are most commonly found where much of the transaction value has been placed on the future prospects of the business, where the target business is in distress or where the future success of the business is largely dependent upon the attributes of the seller, who is to remain involved in an operational role following completion.

There are both benefits and disadvantages of structuring transactions to include an earn out.

The benefit to a seller is that they can benefit from any increase in the financial performance of the business after completion, even though they no longer own the business. This increase in performance may come from synergies and expertise that the buyer can bring to the business following completion and from introducing the business to new customers and markets that the seller would otherwise not have benefited from.

The disadvantage to a seller is that part of the purchase price is dependent on the performance of the business, even though they have less or even no day-to-day control or involvement. They may, therefore, receive less consideration than they had originally expected if there is a downturn in the business or in the market it operates in generally. There may also be tax consequences if the seller remains involved with the business after completion in a more day-to-day role and the earn out payment is linked by HMRC to their continued employment with the business and therefore is classed as income.

The benefit of an earn out to a buyer is that some of the risk for the future performance of the business is apportioned to the seller, and it may, therefore, provide for a more accurate valuation if forecasts or future predictions do not materialise. Earn outs also allow the buyer to defer some of the purchase price and therefore effectively provides a form of finance for the buyer for the purchase.

The disadvantage of an earn out to a buyer is that a seller will often demand some control over the conduct of the business during the earn out period which will prevent the buyer from operating the business freely and making substantial changes. The monitoring required during an earn out period can also be a distraction to a buyer following completion as the seller will typically expect some form of right to continue to inspect the business’ books and records to check on performance against the agreed earn out metrics.

A number of considerations need to be made when negotiating earn out provisions in a transaction. Once they have been agreed, as with all material commercial issues, the transaction documents will need to accurately define what has been agreed to prevent potential disputes. Typically, earn out provisions within the transaction documents will set out the procedure for resolving any dispute and will usually provide for expert determination by an independent firm of accountants if the parties cannot agree if an earn out payment is due, or the amount of such a payment.

The first consideration will be what performance indicators are to be used to calculate the earn out, or whether it will be paid at all. Typical indicators used are financial, such as profits or revenue, but they can be more flexible and include indicators such as whether key customers or employees remain after completion. Whatever the metric used, importantly it needs to be easily ascertainable and quantifiable to prevent potential disputes.

It is common for earn outs to be staged so that the amount of the earn out payment increases, depending on how successful the business is after completion. They can also be structured as more of a ‘cliff edge’, for example only if the business hits an indicator will a sum of money be paid; if it does not, then the earn out sum is lost.

The length of the earn out period is also a key consideration. Typically they will last for up to three years. Too short a period could mean too much focus is placed on achieving performance indicators to the detriment of the business’ long term prospects. Too long a period could mean the earn out becomes a distraction to the buyer. The seller will want to strike a balance between benefiting from the growth in the business, but also the longer the period for payment, the riskier it becomes that the seller will get paid at all. For this reason, the issue of security for the earn out payment should always be raised by the seller during negotiations, whether this is in the form of an escrow arrangement, a guarantee or legal charge. Some sellers will also find it difficult to transition from an owner or manager to employee status and being subject to the new owner’s scrutiny. For this reason they will usually prefer a shorter earn out period.

As the seller will no longer be in day-to-day control of the business, they will want to ensure the transaction documents contain appropriate protections and provisions for the conduct of the business during the earn out period in order to ensure that the buyer does not take any step or action that may adversely affect the amount of the earn out payment. A sensible balance needs to be struck and it is an area which is usually heavily negotiated. The buyer will obviously want to resist any restriction that would hamper its ability to operate the business after completion or from making purely commercial decisions. Typical provisions that tend to be more acceptable to a buyer are undertakings in relation to carrying on the business in the ordinary course and on arm’s length terms or not diverting business away from the business to other companies within the buyer’s group. Restrictions that buyers are likely to resist are undertakings preventing the buyer from making decisions which they would consider commercial decisions, such as incurring additional debt and capital expenditure or taking on additional employees.

Another key area for negotiation around earn out provisions in the transaction documents is the extent to which the buyer has the right to withhold any earn out payment and set it off against potential warranty or tax claims against the seller. Clearly the seller will want to try to resist this and only allow it if the claim has been finally determined or at least when the prospects of success for such a claim are good, rather than to just allow the buyer to withhold an amount at their discretion.

There may also be circumstances when a buyer may seek some assurances from a seller in relation to their conduct during the earn out period, especially if the seller is to remain involved in the business after completion in an operational role. The buyer may, for example, require the seller to undertake that they will not take any action with the intention of artificially inflating the earn out payment at the expense of the long-term prospects of the business.

 

Jonathan Sherman is an associate at Coffin Mew LLP. He can be contacted on +44 (0)23 8048 3751 or by email: jonathansherman@coffinmew.co.uk.

© Financier Worldwide


BY

Jonathan Sherman

Coffin Mew LLP


©2001-2019 Financier Worldwide Ltd. All rights reserved.