In the world of mergers and acquisitions (M&A), one term that often crops up is “earn-out.”
At Thomson Snell & Passmore, we have seen a distinct recent growth in the use of earn-outs in many of our M&A deals – which is perhaps a sign of the times and a potential lack of willingness for buyers to completely shoulder the risk of an investment.
But what exactly is an earn-out, and why should sellers in an M&A context be mindful of it? In this article we will delve into the intricacies of earn-outs; examining the issues and pitfalls associated with their use.
What is an earn-out?
At a very high-level, an earn-out is a financial arrangement involving a contingent payment to the seller of the relevant business, which is dependent on the future performance of the acquired business. In other words, part of the purchase price is deferred and contingent on the achievement of specific targets or milestones of the business after its acquisition by the buyer.
Why use an earn-out?
Earn-outs can be an appealing component of an M&A deal for several reasons:
- Risk mitigation: They can help mitigate the risk for the buyer, as they will only need to pay further consideration for the business if it performs well (or, at least, as expected) post-acquisition.
- Alignment of interests: Earn-outs align the interests of the seller and the buyer as both parties have a stake in the continued success of the business.
- Bridge valuation gaps: If there is a disparity between buyer and seller in the perceived value of the business being sold, earn-outs can bridge the gap by allowing the seller to earn more if the business exceeds expectations.
What are the pitfalls of using earn-outs?
- Complexity: Earn-outs are inherently complex; often involving intricate calculations and extensive legal mechanisms. This complexity can sometimes lead to disputes, and therefore it is imperative that you seek appropriate advice from a Corporate / M&A lawyer who has prepared an article in Insider Media on earn-outs…*very unsubtle plug*
- Earn-out targets: Determining the right targets or milestones for earn-outs can be challenging. Setting targets that are too high can turn-off sellers if they appear to be unachievable, while setting them too low may not adequately protect the buyer’s interests.
- Earn-out period: The duration of the earn-out period is crucial. A longer earn-out period can lead to uncertainty and a lack of control for the seller; whilst a shorter period may not allow sufficient time for the business to meet its targets.
- Market and economic factors: External factors, such as market conditions and economic downturns, can significantly impact a business’s ability to achieve earn-out targets. Sellers might find themselves at the mercy of factors beyond their control.
- Integration challenges: Post-acquisition integration can be disrupted by earn-outs as the seller will almost certainly have different priorities than the buyer.
- Earn-out protections: The use of earn-out protections which seek to prevent any deliberate or inadvertent reduction in the earn-out are standard – but agreeing the length and breadth of those earn-out protections between parties (who may have very different interests) can be difficult.
Before diving into an M&A transaction with an earn-out, it is essential that both the buyer and the seller carefully consider the structure, targets, and duration of these contingent payments.
While earn-outs can be a valuable tool in M&A, they should be approached with caution. Clear communication, a thorough understanding of the terms, and professional advice are essential for both buyers and sellers to navigate the potential challenges that earn-outs can present. If you are considering an M&A transaction, it is always wise to consult with experienced professionals who can guide you through the intricacies of earn-outs to ensure a smooth and mutually beneficial deal.