What Are Earn Outs And How Can They Work?

This article explains what earn outs are, the advantages and disadvantages of using them and how they can be structured in the context of an M&A deal (including management buyouts, or ‘MBOs’).

What is an earn out?

When an M&A deal is scheduled to take place valuations will be put on the target company using a variety of different methodologies with the parties eventually deciding on a value that falls within a plausible range.

Not all M&A deals follow this process, however, and some target companies are instead valued based upon their future profit-generating potential. What then happens is the parties will agree that some of the consideration will be deferred until after completion of the deal, at which point the amount then payable will be calculated by reference to profits actually achieved for specified periods after completion. This is called an ‘earn out’ agreement.

In the context of a typical M&A deal, the sellers are not likely to have much to do with the running of the target company post-completion as one of the aims of selling the business would have been to get a clean break away from it.

However, in scenarios where sellers will still be involved in the operation of the target company post completion, especially where buyers are acquiring an employee orientated company, then earn out arrangements are often implemented with the aim of facilitating a smooth transition post-completion with minimal disruption to the target company.

Why use the earn out structure?

It is often the case that the earn out structure is used where the sellers of the target company will continue to manage it post-completion. In such circumstances, if an earn out structure was not used then the sellers could neglect the effective management of the target company as they would have already received all of the consideration for it. This would in turn lead to the target company becoming less efficient and may lead to it losing customers and therefore reducing its profit-generating potential, particularly where the target company is heavily reliant on employees (i.e. is ‘employee-orientated’).

An earn out structure can therefore be used to incentivise the sellers who are managing the target company and make them want to maximise the potential of the business. This in turn would mean that they would receive more consideration under the terms of the earn out at the end of the specified period, and also would reassure the buyers that the sellers would not neglect the target company when they manage it post-completion.

An earn out is often agreed on as a compromise between a seller wanting to obtain the highest possible valuation for their business and a buyer who wants to make sure they are getting a good deal for their investment and therefore seeking reassurance that the target company is capable of meeting profit targets and measuring up to other performance metrics. An earn out structure will therefore counteract the buyer’s risk relating to the target company’s profit generating potential and will ensure that the buyer does not pay too much for a target company that fails to perform as expected.

Below are some advantages and disadvantages of earn outs from both the seller and buyer’s perspectives:

Advantages of an earn out (seller’s viewpoint)

• Sellers receive the benefit of any synergies that are achieved post-completion. Perceived synergies are one of the main reasons why companies enter into M&A deals in the first place. If the two companies achieve synergies that would not have been obtainable if they had not merged into a larger combined entity, then value will be unlocked and the sellers will obtain a portion of this.
• The sellers will derive the full benefit of selling a profitable business to the buyer. Without an earn out structure in place, the buyers may be reluctant to pay full valuation price for the target company where they are unsure of what it is capable of achieving. Having an earn out in place means that the sellers are more likely to receive a full valuation price (rather than a discounted one) for the target company if it achieves the agreed targets set during the earn out period.

Advantages of earn out (buyer’s viewpoint)

• An earn out allows the buyer to allocate risk – if the target company performs as expected and meets the agreed targets set during the earn out period, then the buyer will reap those rewards. Conversely, if the target company does not meet those agreed targets during the earn out period, then (depending on how the earn out is structured) they may not have to pay the buyer much (or anything) post-completion, therefore acquiring the target company at a discount.
• If the target company that the buyer is acquiring is employee orientated and those employees are staying on to work for the target company or the deal is structured as an MBO, an earn out helps incentivise the employees to maximise the profitability and performance of the company post-completion.
• The buyer has the cash flow advantage that it does not have to pay the full amount of consideration in one go. Part of the purchase price will be deferred until some point post-completion and will only be payable if the target meets the pre-agreed targets during the earn out period.
• An earn out removes uncertainty for the buyer and prevents them paying too much for the target company. Instead of the target company’s valuation being based upon projections and forecasts, what the buyer will pay for the target company will be more based on actual performance during the earn out period.

Disadvantages of earn out (from both seller’s and buyer’s viewpoint)

• Both buyers and sellers will be pulling in different directions so it is often hard to reach agreement on the detail of the earn out arrangement. Sellers will be keen to maximise profitability during the earn out period so as to meet the agreed targets and receive the earn out consideration, while buyers will be less concerned with short-term profits and instead will want the target company to focus on making decisions that will lead to the company’s long-term prosperity.
• The parties do not necessarily achieve a “clean break” following completion. Under an earn out structure the sellers will continue to be involved in the day-to-day functioning of the target and will want to ensure that the buyer is limited as to what it can and cannot do with the target during the earn out period, such constraint being a disadvantage for buyers.
• As the parties are more than likely to be pulling in different directions, such an environment breeds fall outs and disagreements between them. Consequently, the parties may need to spend time, money and resources on settling disagreements, including via pre-agreed dispute resolution procedures in their earn out agreement.
• A target company not doing as expected in the earn out period may not necessarily be down to its performance. There are various internal and external factors (i.e. political and economic) that are out of the target company’s control but which may nevertheless impact on how it performs. These factors may lead to targets not being reached and earn out consideration not being paid due to no fault on the seller’s part.
• The post-completion monitoring and measurement of the target company’s performance that an earn out requires the buyer and target company’s management to conduct may be costly and time consuming.

How are earn outs structured and how do they work?

Using a classic earn out structure, the earn out would be calculated by reference to the target company’s profits over a number of financial periods following completion. These financial periods could be whatever the parties chose them to be – the seller may want them to be relatively short so that they receive the rest of the consideration quicker, whereas the buyer may want them to be longer so they get a true picture of how the target company performs. There are less common earn out structures that could be used – for example ones that assess the target company’s net assets over time or the number of units sold.

How the earn out consideration will be calculated is largely transaction specific and will be a matter to be negotiated by the parties to the deal. The parties could agree that the sellers are to be paid a set percentage of the target company’s profits during the relevant earn out period. Alternatively, the earn out could be structured in a way that meant that the sellers would only be paid if set performance targets are met (i.e. the payments are contingent). A seller is likely to resist such a structure because this would mean that if the target company were not to achieve the set targets, then they would not receive the contingency payments. Buyers may prefer this option as it gives the sellers an incentive to maximise the earning potential of the target company if they are to stay on and manage it post-completion and, in addition, it means that they don’t have to pay the sellers anything if the agreed targets are not achieved during the earn out period.

When structuring an earn out, the parties should negotiate and agree upon the following aspects:

• Agree on which of the parties’ accountants will be responsible for providing the accounts for the earn out period. The parties will want to agree on the precise definitions of those items which will impact/determine the amount of the deferred consideration, such as ‘net profit’ or ‘earnings’. If the earn out structure is to be profit based, then the parties will need clear provisions on how the profit figure is to be calculated and also an agreed definition of what profit is in the first place. For example, the parties could decide to produce the accounts in compliance with UK GAAP (UK Generally Accepted Accounting Principles).
• The parties should agree upon the financial or operational metrics that will be used as benchmarks for calculating the earn out. Sellers typically prefer revenue orientated metrics as they are less susceptible to manipulation by the buyer and are less affected by costs and expenses. Buyers on the other hand will resist revenue orientated metrics, particularly where the seller will continue to manage the target company post-completion, because such metrics do not motivate the seller to control costs and expenses (only to maximise revenue). Whatever kind of financial or operational metrics the parties decide upon as benchmarks for calculating the earn out, they should ensure that they are: clearly defined; objective and easily measurable and are compatible with the nature of the target company’s operations.
• Decide the length of the earn out period. A typical earn out period would be between one and three years following completion.
• Decide the amount of the earn out payments. Will they be a percentage of the profit of the target company for a set period or will they be contingent upon the target company meeting set targets?
• Decide on whether the earn out payments will be calculated with reference to the target’s audited accounts or whether special earn out accounts should be drafted.
• The parties will also need to agree upon how the target company will be operated post-completion. The seller’s right to any earn out payments is dependent on how the target company performs post-completion. They are therefore vulnerable to any actions the buyer may take that could adversely impact on the earn out. Sellers should therefore seek contractual protections that the buyer will carry on the target company’s business in the ordinary course and that it will not make any material changes to the business.
• Decide on the dispute resolution procedure to be used should there be a disagreement between the parties – for example if they disagree on the definition of what constitutes ‘profit’ then there should be a mechanism where an independent accountant is appointed whose decision is agreed to be binding.

What are the pitfalls of badly drafted earn outs?

Failing to adequately draft an earn out agreement may lead to a variety of setbacks and pitfalls that will put both buyer and seller at a disadvantage. The following are just a few consequences of failing to effectively produce an earn out agreement.

• Failure to properly provide for how disputes will be resolved can lead to time delays, further disagreements developing and the creation of a frustrating start to your business relationship.
• Attempting to produce a massively detailed and convoluted earn out agreement can heighten the risk of subsequent disputes. The key is to keep the agreement as clear and as simple as possible so that both parties are agreed on definitions, the length of the earn out period and what both parties are allowed and not allowed to do during that period in relation to the target company.
• Failing to set out clearly the mechanics of the earn out agreement. Agree on whether the earn out consideration is calculated by reference to financial or performance metrics (or both) and how the consideration will be paid. For example, will the earn out consideration be paid as a percentage of the target company’s profit or will the earn out consideration only be paid if the target company meets set profit targets? Failure to properly accommodate the earn out mechanics in the agreement can lead to the parties misunderstanding how the earn out actually works which will lead to disappointments and potentially disputes in the future.
• A poorly drafted earn out can result in the earn out consideration payment to the sellers (management) being treated as employment related income, which will result in negative tax implications.

Summary

Using a properly drafted earn out can be an effective mechanism for incentivising sellers to achieve post-completion targets and giving the buyer reassurance that they are buying a company for a good price based on tangible post-completion targets being achieved. Earn outs can provide advantages for both parties in an M&A deal and can allow the business relationship between them to flourish post-completion if the earn out agreement is well produced.