Alternative pricing structures: earn-outs

You have found a buyer for your business (or a business you wish to acquire), but are having difficulty coming to a final agreement as to price.  In this situation, alternative pricing structures are worthy of consideration.  Following on from our previous article on structuring the sale of your business, we take a look at earn-out arrangements and the part they can play in bridging the price gap between a buyer and a seller.

What is an earn-out?

Earn-out provisions defer payment of part of the purchase price by providing for payment of an additional amount at a future date.  The payment is contingent on the achievement of specified milestones or hurdles post-sale which may be based on financial performance or they may be non-financial, such as the retention of key customers or achievement of certain regulatory approvals.  The payment may also be variable depending on the level or timing of the particular milestone or hurdle.

These arrangements often arise where the parties cannot agree on value. This usually occurs when the seller has an optimistic view of the future growth and value of the business, whereas the buyer is not willing to bank on this outcome and pay for it whilst unproven.  An earn-out can give the buyer protection against overpaying for the business as the additional amount only becomes payable if, indeed, the future value of the business proves to be true by achievement of hurdles or milestones. This also allows the seller to be appropriately compensated when they are confident of the future performance of the business.

This may seem straightforward, but unless carefully drafted and thought through, the provisions can be fraught and open to “gaming” or manipulation by one or both parties.

Earn-out protections

Consider an earn-out that is based on future earnings.  The seller of a proven and growing business may be confident of its financial projections, however, it is important to remember that the seller will not be controlling the business during that earnings period as the business will be sold.  Whilst ordinarily the parties’ interests are aligned in maximising the future value of the business, earnings could be severely impacted by other matters, such as if the buyer elected to sell off a large quantity of income earning assets, lost a key customer, wound up part of the business, or a number of other decisions or matters that are outside of what the seller would have contemplated if it had remained in control.

In some cases, it may be that after the sale the seller remains in charge of operating the business for the earn-out period on a contracting or employment agreement.  Although this appears to put the seller in charge of its ability to achieve the earn-out, the seller will still need to ensure that its ability to achieve the earn-out milestones cannot be fettered or frustrated by the buyer as the new owner, for example by cutting the marketing budget or sales staff.  This should be covered when drafting the agreement.

If the seller is leaving the business, it will be important to include a suite of contractual earn-out protections.  These protections will either restrict the buyer’s actions in respect of the business prior to the earn-out trigger date, for example, restricting asset sales or the termination of key customer contracts, etc.  It can also provide for acceleration of payment of the earn-out amount if the buyer wishes to pursue such actions.  The protections should, at the least, require the buyer to run the business in a manner consistent with past practice and seek to maximise the earn-out.  This is the potential downside for a buyer in agreeing to an earn-out clause.  In deferring payment of the purchase price and making it contingent on milestones, the buyer will inevitably have to accept some restriction or obligation to reasonably protect the seller with regard to achieving these milestones.

Parties should also consider the consequences of issues and events that are outside of either of their control, such as market downturns or natural disasters, and what impact they may have on payment of any earn-out amount.

Clear contractual provisions

If carefully drafted, earn-outs can deliver wins for both a buyer and a seller.  They can bridge the gap where the parties cannot agree on final price and align the incentives and motivations of the parties going forward.  Equally, however, they can lead to disappointment and disputes as the provisions have the potential to be “gamed” by the parties by their actions post-sale.

Recent case law has shown us that when a dispute arises, the courts will look at the rationale and commercial purpose of the earn-out provision and what it considers must have been the “commercially sensible” intention of the parties.  In this regard, it should be noted that earn-outs are traditionally designed to confirm the value of the business at the time of sale (or “put it to the test” based on future earnings or achievements), not necessarily to compensate the seller for future value uplift created by the buyer post-sale.

If you are considering the sale or purchase of a business, please do not hesitate to get in touch with the Business Law team at Lane Neave to discuss the options available to you.

Business Law team

If you need any assistance, do not hesitate to get in touch with the Business Law team at Lane Neave.

Gerard DaleClaire EvansGraeme CrombieEvelyn JonesAnna RyanJoelle Grace,  Peter OrpinEllen SewellMatt TolanCarlo WanKristina SutherlandJacob NuttWhitney MooreAlex StoneBen Cooper, Lisa Catto

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