What is an “Earn-Out”?
21st February, 2020
An earn-out is the term used to describe a transaction that occurs on the sale of a company’s shares or its business when the purchase price is based on the performance of the target business following completion.
For example, a buyer may make an initial payment on completion of the transaction with payment of deferred consideration being conditional on the future financial performance of the target business during an agreed time period following completion.
When are they used?
An earn-out will often be used in circumstances where the buyer and the seller disagree on the value of the target business and/or its projected financial position. A buyer may look to use an earn-out if it has limited access to funds, whereas a seller may prefer to have an earn-out if the target business has potential for future growth (such as the introduction of a new product which could significantly increase profits).
What to include?
The following points should be addressed:
- Length of the earn-out period.
- Payment schedule.
- Determining how performance will be measured and defined.
- Process for resolving any disputes between the parties.
A seller may want to include provisions commonly referred to as “earn-out protections”, such as restrictions on what a buyer can or cannot do in relation to the target business during the earn-out period. Restrictions on the following are commonly included:
- Diverting business opportunities away from the target business.
- Taking any action that could distort the financial position of the target business.
- Disposal of all (or a material part) of the target business or changing its scope.
- Intra group management charges or fees being charged to the target business.
A seller may also want access to financial information concerning the target business during the earn-out period. Whilst this should be acceptable to a buyer, it will likely want to ensure that it is not going to cause a disproportionate amount of effort (such as a requirement to provide monthly management accounts when its current practice is to only prepare quarterly management accounts).
Advantages for a buyer include:
- Protection from overpaying given that the value of the business will be based on future performance, not predictions.
- Less capital is needed at the time of purchase and the target business earnings may be used to help fund any earn-out payments.
- Encouraging a seller (or its shareholders) to stay in the business and help drive future growth.
Advantages for a seller include:
- Without an earn-out a buyer may only be prepared to pay a discounted price if it has doubts over the target business’ projected future earnings.
- The target business being part of a larger group may assist its performance, thereby increasing the purchase price payable.
Potential disadvantages include:
- The focus of a seller continuing in the business may be on the short-term strategy of running the business in order to increase profits quickly, which could have an adverse impact on the long term profitability of the business.
- A seller may seek to impose restrictions on how a buyer may run the target business during such period in order to protect the potential earn-out.
- A seller may get less favourable tax treatment on the earn-out proceeds than it would have had the proceeds been paid in full on completion.
If you have any questions in relation to this article or in relation to a sale or purchase of a company or its business please contact Jamie Hawley
Corporate & Commercial
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