An earn-out arrangement is an arrangement commonly used in mergers and acquisitions (M&A). An earn out arrangement is where part of the purchase price for a business relies on the performance of the target company.
In other words, part of the payment that the buyer makes to the seller is determined by how well the business performs after the acquisition. This is often based on specific financial criteria or other performance indicators.
Earnout arrangements add a layer of complication to the purchase of a business. For this reason, it is important to consult with a business purchase lawyer (if you are the buyer) or a business sale lawyer (if you are the seller).
How does an earnout arrangement work?
Here’s how earnout arrangements typically work:
Business Purchase Agreement for Earnout Arrangements
When a buyer purchases another business, they negotiate the terms of the business purchase agreement. This agreement will include details about the purchase price, payment structure, and other terms.
In earnout arrangements, a portion of the purchase price is dependent on the future performance of the target company. This means that the actual amount paid as part will be determined based on certain agreed-upon performance criteria.
The earn-out is tied to specific performance metrics. This could include revenue targets, profitability levels, customer retention rates, market share, or other relevant indicators. These metrics are usually measured over a certain period of time, such as one to three years after the acquisition.
The earn-out payment is structured so that the buyer pays the seller additional amounts if the relevant metrics are met. The payment schedule and conditions are detailed in the business purchase agreement.
Risk and Reward
Earn-out arrangements carry both risks and potential rewards. The buyer takes on the risk that the business’s performance might not meet financial metrics. And this would result in a lower earn-out payment. On the other hand, if the business performs well, the seller has the potential to receive a higher payment than initially agreed upon.
Earn-out arrangements can be beneficial in certain situations. For example, they can help bridge the valuation gap between a buyer and a seller when their expectations about the value of the business differ.
They can also align the interests of the seller with the ongoing success of the business, as the seller will have a vested interest in achieving the performance targets.
However, earnout arrangements can also be complex and lead to disagreements between the parties if there’s ambiguity in the terms or a difference in interpretation regarding the achievement of the performance metrics.
To avoid potential issues, both parties need a clear and comprehensive earn-out agreement that outlines the metrics, measurement methods, payment terms, and dispute resolution mechanisms.
The earnout mechanism
Earn-out mechanisms are the specific ways in which the contingent payment structure of an earn-out arrangement is implemented. These mechanisms define the performance metrics, calculation methods, payment schedules, and other details that determine how much of the purchase price will be paid out based on the performance of the acquired business. There are several common earn-out mechanisms:
Revenue-Based Earnout Arrangements
In this mechanism, the earn-out payment is tied to the revenue generated by the acquired business. The acquiring company and the seller agree on a target revenue figure, and the earn-out payment increases as the actual revenue surpasses this target.
Similar to the revenue-based earn-out, this mechanism uses the profitability of the acquired business as the performance metric.
The earn-out payment is calculated based on achieving a certain level of profit. For example, EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortisation), net income, or other profitability metrics.
Customer Retention-Based Earn-Out
This mechanism focuses on customer relationships and retention rates. The earn-out payment is contingent on maintaining a specific percentage of existing customers after the acquisition.
Product Development or Milestone-Based Earn-Out
If the success of the acquisition hinges on the development of new products or achieving certain milestones (such as regulatory approvals), the earn-out can be linked to the successful completion of these objectives.
Market Share or Growth-Based Earn-Out
Here, the earn-out payment is based on the acquired business’s ability to gain market share or achieve specific growth targets within a certain time frame.
Earn-out arrangements can combine multiple performance metrics to create a more comprehensive payment structure. For example, a hybrid mechanism might involve a combination of revenue, profit, and customer retention goals.
Tiered Structures for earnout clauses
In some cases, earnout arrangements are structured in tiers. This means that different performance levels trigger different earn-out payment percentages. For example, if the acquired business exceeds a certain revenue threshold, the earn-out payment might increase from 10% to 15% of the target amount.
Instead of being tied to specific performance metrics, the earn-out payment could be paid out over a defined period, regardless of the business’s performance. This is less common and may be used when other criteria are difficult to establish.
The effectiveness of earnout arrangements heavily relies on the clarity and precision of the agreed-upon mechanisms. Ambiguities or poorly defined terms can lead to disputes between the buyer and the seller.
Due diligence and thorough negotiation are essential to creating a fair and workable earnout calculation. And, one that aligns the interests of both parties and reflects the realistic potential of future economic performance.
Where to start with negotiations
As with any negotiation, it is important to understand what the interests and goals of the other party are. This will help the person negotiating the earnout clause to determine whether there is any alignment between the parties, or where compromise needs to be made.
Earnout structures can be complicated, particularly for a larger business that is being acquired. For this reason and many more, it is key to ensure that the parties have expert advisors to explain the impact of any proposed earnout clause.
Key considerations for the purchase contract
Remember, an earnout payment is generally considered part of the purchase price of an acquired company. Because of this, each party needs to seek appropriate advice regarding their taxation obligations concerning the transaction.
For example, look through CGT treatment that may apply to earnout arrangements in a given financial year. Here is some more information on earnouts and capital gains tax. Sellers should also consider whether any CGT concessions may be available to them.
Uncertain earnout rights
Having uncertain earnout rights in a business acquisition can have several impacts on both the buyer and the seller. These uncertainties can arise due to factors such as:
fluctuating business performance
changing market conditions
differences in interpretation of the earnout terms
Example of an earnout clause
Earnout clauses can be drafted in many different ways. An example of an earn-out clause in a sale agreement could be as follows:
The Parties agree that a portion of the Purchase Price shall be paid as an earn-out (Earn-Out) as follows:
The Seller is entitled to receive additional consideration based on the performance of the Target after Completion. The Earn-Out period shall be for three (3) years following the closing date (Earn-Out Period).
The Earn-Out shall be calculated based on the Target’s EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortisation) during the Earn-Out Period. If the Target’s EBITDA exceeds $X during the first year of the Earn-Out Period, the Seller shall receive an additional payment of $Y. If the Target’s EBITDA exceeds $A during the second year of the Earn-Out Period, the Seller shall receive an additional payment of $B.
The Earn-Out shall be paid within thirty (30) days following the end of each year of the Earn-Out Period, after the Target’s financial statements for such year have been finalised and audited.
The Seller shall have the right to review and audit the Target’s financial statements and records for the purpose of verifying the calculation of the Earn-Out.
This clause is designed to align the interests of the buyer and seller after completion. It also provides the seller with the opportunity to participate in the future success of the business.