Earn-Outs: Narrowing The Value Gap Between Buyers And Sellers

 

When the buyer and seller are far apart on the valuation of the business, negotiations will not be easy. Price expectations can be narrowed when both sides agree on an earn-out provision in the acquisition contract. An earn-out is a complicated legal concept that, when crafted by a business attorney well experienced in representing buyers and sellers, helps close the value gap and bring a buyer and seller together to close the deal.

Earn-out

An earn-out involves the seller of a business obtaining additional compensation in the future, based on the purchased company meeting certain financial goals. For example, the financial goals can take the form of earnings or a percentage of gross sales. This is a common tool used during negotiations when a business owner selling their business wants a higher price than what a buyer is willing to pay.

Considerations

There are many key issues that can be involved in the negotiation with an earn-out.

  • What is the time period covered by the earn-out?
  • Which owners and non-owner will be offered the earn-out?
  • Which current owners and non-owners will be part of the business with the new owner?
  • What position will current executives have within the acquired company?
  • What metrics will be used to determine the earn-out?

A contract with an earn-out provision could follow common accounting principles, but decisions will still need to be made by key managers who could influence performance results. A buyer needs to determine if an earn-out will help the business by increasing revenue or market share or harm future operations, for example by achieving growth in revenue at lower margins.

Expectations

When a seller’s business has a history of meeting or exceeding earnings forecasts, this can help demonstrate the benefits of an earn-out during negotiations with a buyer and clarify earn-out terms placed in the contract. A seller may be able to get a larger percentage of the purchase price upfront with a lower percentage paid after a few years with earn-out payments. Also, a buyer may agree to terms if an owner stays with the company for a few years to maximize the company’s performance.

Conditions

A seller will be very concerned with protecting this future purchase price opportunity. They may want to establish specific conditions that are designed to impact the buyer’s management after the acquisition. In many cases, an earn-out will be based on a company meeting product sales or revenue milestones. To ensure this happens, a seller may require conditions that a buyer maintain the seller’s policy with regards to advertising, selling, marketing, etc. This may be contrary to the buyer’s post-sale plans. Negotiating an earn-out can be a problem when both parties have conflicting interests.

Metrics

Different economic performance targets can be used for an earn-out clause in a contract. Some could be net income, revenue, earnings before interest, tax, depreciation and amortization (EBITDA), and earnings before interest and taxes (EBIT). Earn-outs can also be based on non-financial metrics such as execution of contracts with third parties, the development of certain products, and more. Many sellers choose revenue as it is the simplest way to measure performance. The disadvantage is that revenue can increase and still not improve a company’s bottom line. Buyers often prefer net income. This can put the seller at a disadvantage since they have less control of profitability than they do of sales.

Limitations

An earn-out clause is most effective when a company is being successfully operated at the time of the agreement and can maintain its success well into the future. However, should significant changes in a company’s operations take place after the transaction, it could have a very negative impact the amount of an earn-out. Business buyers and sellers who are considering making an earn-out part of their negotiations need to make certain they understand its limitations. Unintended consequences can result to the disadvantage of one side or the other.

On one occasion, while representing a large public company, I negotiated an earn-out based on sales. The seller wanted a proportionate earn-out: 80% of target in a certain time period meant a payment of 80% of earn-out money. I said, “no, you told me 100% was a no-brainer, that the buyer should offer the earn-out as additional purchase price because the sales were all but guaranteed, and the deal was sold to my board of directors on that basis.” So, using the seller’s own words against him, I got a “cliff” earn-out for my buyer-client. If the seller hit or exceeded the target, he received 100% of the earn-out. If he missed, to any degree, his earn-out opportunity fell off a cliff and he got zero. The seller missed, got a zero earn-out, and the buyer got a great deal because the promised sales occurred after the earn-out period had expired. Thus, the earn-out language placed in any contract needs to be carefully considered and drafted by an experience business transactions attorney who can help you navigate these nuances.

Risks

It’s also possible for earn-outs to be a risk for all parties involved in the transaction. The sellers will want to increase the chances of the company achieving their earn-out goals. They may want to have restrictions on how the company can operate after the closing. Many sellers feel confident that if the company maintains their processes, their earn-out will likely happen. Buyers do not like to have such restrictions on their management and future plans in a contract. Many reject the idea of being told how they can operate the business after the closing. Even when the seller is able to include some restrictions, their earn-out will still be at risk. Their earn-out payment will still be based on the buyer’s success with the company. A seller needs to realize that they are an unsecured creditor when it comes to being paid an earn-out, and a buyer could try to limit their earn-out obligation with language in the indemnity section of a contract.

Future Acquisitions

When creating an agreement with an earn-out, both sides also need to consider future acquisitions. The buyer could sell the business to another company and the earn-out could then be in jeopardy – unless there is language in the agreement to address this situation. If a buyer transfers their shares to another business, it needs to be determined who will be responsible for meeting the obligations of the original earn-out. For instance, it might be possible to negotiate a cash-out upon acquisition to have the earn-out paid in full.

Earn-outs can be highly beneficial when added to a contract for the sale of a business. But capitalizing on the maximum value of a business and helping to get as much of the value as possible into the sellers’ pockets requires an attorney experienced in these types of business transactions – experienced as in seeing a great number of seller-buyer situations, knowing how to help protect their client from the many ways a business deal can fail, and knowing how to find opportunity in their client’s unique business situation.

John H. Walker

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Written by Walker Law PC

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