Earn-Outs in M&A: Key Legal Considerations
In any business or company sale, pricing is a critical aspect that can often be contentious, especially when there is a gap between the buyer’s and seller’s valuation of the target business. To bridge this gap, parties frequently use earn-outs—a pricing mechanism that ties a portion of the purchase price to the future performance of the target business. While earn-outs can offer a win-win solution, they also introduce legal complexities that must be carefully managed through meticulous drafting and negotiation.
Overview of Earn-Outs
An earn-out is a contractual provision where a portion of the purchase price is contingent upon the achievement of specified performance targets by the target company post-closing. These targets are often tied to financial metrics such as revenue, EBITDA, or net income but can also include non-financial benchmarks like product development milestones or customer acquisition goals.
Earn-outs are particularly useful when there is uncertainty about the future performance of the target or when the buyer and seller have divergent views on the company’s value. For the seller, an earn-out represents an opportunity to capture additional value if the company performs well. For the buyer, it mitigates the risk of overpaying for an underperforming business.
Legal Structuring of Earn-Outs
The legal structuring of earn-outs is complex and requires precise drafting to avoid disputes. Key elements that need to be addressed include:
- Performance Metrics and Targets: Clearly defining the metrics that trigger earn-out payments is essential. Vague or overly ambitious targets can lead to disputes. Lawyers should ensure that these metrics are measurable, objective, and within the reasonable control of the target’s management. Providing worked examples in the sale agreement as to how the earn-out is calculated can provide clarity and minimise the chance of disputes.
- Timeframes: The earn-out period must be explicitly defined, typically ranging from one to three years post-closing. The parties should also agree on the frequency of performance assessments, such as quarterly or annually.
- Payment Terms: The agreement should outline when and how earn-out payments will be made, including whether payments will be made in cash, shares, or a combination of both.
- Accounting Principles: The earn-out provision should specify the accounting principles or methodologies to be used in calculating performance metrics. This includes addressing revenue recognition policies, expense allocations, and any adjustments for extraordinary items that could skew the results.
Challenges and Mitigation
Earn-outs, while having many advantages can lead to disputes between the parties, often stemming from differing interpretations of performance results or disagreements over management decisions that impact the earn-out calculation. Key challenges include:
- Manipulation of Performance: There is an inherent risk that the buyer, who controls the business post-closing, might make decisions that adversely impact the earn-out, such as reallocating resources away from the target or integrating it in a manner that diminishes its standalone performance.
- Mitigation/Principles: To address this, earn-out clauses can include covenants or other earn-out principles that obligate the buyer to operate the business in such a manner so as to maximise the earn-out payment, including in accordance with a pre-agreed business plan or budget or otherwise in accordance with past practices. Additionally, sellers may negotiate for veto rights over significant decisions affecting the business.
- Dispute Resolution Mechanisms: Given the potential for disputes, parties should include robust dispute resolution mechanisms within the earn-out provisions. A common approach in the sale agreement will provide for the appointment of an independent accountant to resolve disagreements over financial calculations.
Earn-outs, while not without their challenges, offer a flexible solution to price negotiations in M&A transactions. With thoughtful legal structuring, they can serve as an effective bridge between buyer and seller expectations, ultimately facilitating deal closure and aligning the interests of both parties.
Article written by Nav Mesbah (Associate) (admitted in Scotland and not admitted in Australia)
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