Earn-out arrangements are commonly used in mergers and acquisitions to bridge gaps between buyer and seller valuations of a target business. Under an earn-out arrangement, a portion of the purchase price (usually calculated as a percentage of future earnings) is deferred and contingent on the business meeting certain predetermined performance targets.

The use of earn-out arrangements can benefit both buyers and sellers. The seller can potentially receive a higher purchase price if the business performs well in the future, while the buyer is provided with some protection against overpaying for a business that may not perform as expected. Earn-outs can, however, be complex and require careful negotiation and drafting to ensure the terms are clear and enforceable.

In this article, we look at the basics of earn-out arrangements,  their advantages and disadvantages, and our top tips for negotiating and documenting earn-out arrangements.

What are earn-out arrangements?

An earn-out is a contractual arrangement under which the buyer agrees to pay a portion of the purchase price for a business to the seller at a later date, if certain agreed-upon targets are met. Earn-outs typically take place over a period of one to three years and can be based on financial metrics (such as revenue, EBITDA, or net income) or other performance indicators (such as customer growth or product development).

Why use earn-out arrangements?

There are several reasons why buyers and sellers might choose to use earn-out arrangements in an M&A transaction:

Addressing valuation disagreements

In an uncertain economic environment, earn-out arrangements can help bridge the ‘valuation gap’ between the buyer and the seller regarding the value of the business. If the buyer and the seller have different expectations about the future growth potential of a business, the buyer may be hesitant to pay the full asking price upfront. By agreeing on future performance targets, the parties can set a baseline for what they expect the business to be worth and negotiate payment terms based on that expectation.

Mitigating risk

When a buyer acquires a business, their valuation of it will be based on certain assumptions about future earnings potential and growth prospects. These assumptions are derived from the information available at the time of the acquisition. There is inherent uncertainty associated with these projections, so the actual performance of the business may differ from what was originally expected.

Utilising an earn-out arrangement, the buyer can mitigate some of this risk by linking a portion of the purchase price to the future performance of the business.  If the business performs well after the acquisition, the buyer will be required to pay the earn-out to the seller.  However, if the business does not perform as expected, the buyer may not have to pay the earn-out or may only be required to pay a reduced amount. In this way, earn-outs enable the buyer and seller to share some of the risk associated with the acquisition.

Aligning incentives

Earn-out arrangements can also help align the incentives of the buyer and seller, as both parties have a shared interest in ensuring that the business performs well after completion of the acquisition. This can be particularly useful if the seller is to remain involved in the business post-acquisition, as they are incentivised to ensure the business continues to perform well.

Preserving cash flow

An earn-out arrangement can allow the buyer to preserve cash flow in the short term, as they need not pay the full purchase price upfront. This can be particularly useful if the buyer needs to invest in the business post-acquisition to drive growth or if they are already carrying a significant amount of debt.

What are the drawbacks of earn-out arrangements?

While earn-out arrangements can be a useful tool for structuring M&A transactions, there are also drawbacks to consider:

Complexity

Earn-out arrangements can be complex and time-consuming to negotiate, as they require detailed financial projections and agreement on metrics that will be used to measure performance. Issues may arise around the calculation of earn-out amounts, the timing of payment, and the parties’ obligations during the earn-out period. Additionally, tracking and verifying performance over the earn-out period can be challenging, which can lead to disputes between buyer and seller.

Uncertainty

The future performance of a business is inherently uncertain, which can make it difficult to agree on the financial targets for an earn-out arrangement. Additionally, external factors such as changes in the economy, industry, or regulatory environment can impact business performance. This can make it challenging to accurately predict future earnings.

Integration challenges

Earn-outs have the potential to create integration challenges for the buyer, especially if the seller remains involved in the business. This can lead to conflicts over decision-making. They can also cause misaligned incentives between the buyer and the seller. For example, the seller may prioritise short-term financial results at the expense of long-term growth to maximize their earn-out payment.

Risk of non-payment

Even if the business performs well, there is always a risk that the buyer will not make the earn-out payment. To mitigate this risk, sellers commonly seek a form of security in respect of the buyer’s obligation to pay a deferred earn-out payment.

Top tips for negotiating and documenting earn-out arrangements

Negotiating and documenting earn-out arrangements can be complex, and it’s important to approach the process carefully to ensure that the arrangement is fair, clear and legally enforceable. Here are some of our top tips for negotiating successful earn-out arrangements that benefit both parties:

1. Clearly define the metrics that will be used to measure performance, the timeframe for achieving the performance targets, and any other details relevant to the calculation of the earn-out payment. Determine whether payments will be based on revenue, profit, or other performance measures, and how will the payments be structured (i.e. payable in cash or equity, by lump sum or installments). Clearly define the circumstances under which the earn-out payment will be made.
2. Understand the risks associated with earn-out arrangements including potential changes to the market, industry, and regulatory environment. It may be necessary to account for these risks by, for example, setting floors or caps on payments.
3. Address integration issues including whether the seller will be involved in the business post-acquisition, and if so, how their continued involvement will impact the earn-out arrangement. Both parties should have a common understanding of how decision-making will be handled and the extent of the seller’s involvement in the business during the earn-out period. Any restrictions on the seller’s role that could impact the earn-out payment should be outlined.
4. Consider each party’s motivations and incentives for entering into the earn-out arrangement. This can assist in structuring the arrangement in a way that aligns with the priorities of both the buyer and the seller.
5. Prepare for contingencies – determine how the earn-out will be handled if, for example, the business is sold, or the seller leaves the business before the earn-out period is complete.
6. Outline a process for resolving any disputes that arise over the earn-out payment. This may include expert valuation, mediation, arbitration, or other dispute resolution mechanisms.
7. Be prepared to walk away if a suitable arrangement cannot be agreed – it may be better to avoid a transaction if the terms are not in your interests.
8. Finally, it’s important to seek professional advice from lawyers, accountants and other experts when negotiating and documenting an earn-out arrangement.  This can help ensure that the agreement is legally enforceable and takes into account all relevant legal and tax considerations.

Negotiating and documenting earn-out arrangements requires careful attention to detail and a thorough understanding of the legal and financial implications. By following these tips, both buyers and sellers can ensure their earn-out arrangements are comprehensive, transparent, and designed to achieve their objectives.