Sellers and buyers often have difficulty reaching agreement on a company’s value.
For example, a seller may value their company based on its projected earnings, but this is highly speculative and sellers often overestimate their prospects.
One way to handle this difference of opinion is for the buyer to accept a seller’s valuation at face value and make their offer conditional on the seller receiving part of the purchase price on an earn-out basis.
This seems simple, but disagreements can arise. Let’s take a look.
In this article we cover:
Why do earn-out disputes arise?
Here are some reasons why earn-out disputes arise:
- The seller has presented an over-optimistic view of the target company’s prospects, and the over-ambitious performance measures are now disputed
- The earn-out clauses in the sale agreement are ambiguous
- The parties disagree on how to calculate the performance measures
- After the sale, the seller maximises short-term performance to the detriment of the company’s longer-term financial health
- The buyer struggles to integrate the target company into its group causing a dip in performance that’s unrelated to the underlying merits of the target
- The performance targets may be too close to call with sufficient accuracy
- The parties dispute how accounts have been prepared
- The parties may not have thought about what happens if, say, the buyer decides to sell the business
Avoiding earn-out disputes in sale purchase agreements
Unfortunately, earn-out disputes are common. The best way to protect yourself, whether you’re a buyer or a seller, is to make sure you follow these rules:
- Be realistic when you set targets. If you’re a seller, don’t be over-optimistic as you’ll be storing up problems down the line
- Try to avoid over-complex calculations and measurements, as these can be fruitful areas for dispute
- If, as a seller, you will be staying in the company post-completion, try to keep key members of staff, negotiate a reasonable earn-out period, and consider vetoes over buyer decisions that could impact your pay-out
- Make sure you nail down what happens if external events adversely affect the company’s performance post-completion
Earn-out structure
Here are some key points to consider when structuring an earn-out:
The earn-out clause should at a minimum include:
- A clearly defined earn-out period, with benchmarks and timings for earn-out payments
- Performance indicators (KPIs) that are directly relevant to the business
- Metrics for measuring the KPIs and how disputes will be handled
- What the seller’s role will be during the earn-out period
- Rules for how the company will be managed post-sale so that disputes can be avoided if poor management causes performance to dip
- A dispute resolution mechanism
- What targets will trigger earn-out payments, and whether they are financial or non-financial (customer churn, regulatory approval for example)
- The length of the earn-out period, and the payment dates
- Whether there’s a single end payment or stage payments?
- Will interest be payable on late payments?
For more information, see our article How to structure and negotiate an earn-out.
Calculation of the earn-out amount
An earn-out amount can be a set sum payable on achievement of the relevant target, or a series of variable amounts. The earn-out amount may be a percentage of profits or a multiple of that amount, and these sums could be capped or subject to a minimum. The earn-out sum may be payable in cash, or in some other way, such as shares.
Variation in performance
When debating earn-out targets, think about how to tackle variations in performance.
- Can you smooth this over time so that if the business over-shoots in one period but under-achieves the next, for example, this can be ironed out?
- Can the buyer claw back earn-back payments made in one year, if the company fails to perform in the next period?
Defaults
Will the buyer accelerate an earn-out payment if the seller breaches a covenant in the sale purchase agreement, or sells the company, or it becomes insolvent?
Calculation of performance
- Will you use management or statutory accounts to measure performance? Who will do the calculation, the buyer or the seller?
- Will you limit the period during which the parties agree the calculations?
- What accounting principles will you use, and will you set any policies around this?
- If the buyer’s accountants prepare the accounts, will the seller be able to question or challenge them?
- What happens if they disagree, and are there any time limits for raising objections?
- Will the seller have access to the data used to make the calculations?
Dispute resolution procedure
- If the seller and buyer can’t agree how to resolve a dispute, what happens next?
- Will you appoint an expert to adjudicate, and how will you choose them?
- What will their scope be, and what procedure will they use?
- Will both sides be able to ask questions and make challenges?
- Who will pay the expert’s costs?
Merged operations
It can be difficult to measure performance accurately, particularly if a company has been merged into the buyer’s business. Sellers should insist that the buyer keeps separate books and records for the target. You could also agree to calculate performance on a consolidated basis, allocating a specific percentage to the target company’s operations.
Delaying the start of the earn-out period
You may be able to delay the start of the earn-out period so that the target can ‘bed-in’ to new management and absorb any exceptional costs relating to the acquisition.
Practicalities
Make sure that you’ve allowed enough time to prepare the earn-out calculations, and make sure your staff and advisors are available.
Length of the earn-out period
Buyers should avoid long earn-out periods as this may give an unrealistic picture of the target’s underlying merit. They should also avoid a too-short period so that the target has time to absorb the acquisition costs.
Other provisions
These clauses can also be helpful:
- Agree that disputes will be only resolved by arbitration or conciliation, and limit the range and scope of matters that can be considered.
- Avoid ‘all or nothing’ payments that are contingent on targets being met; instead agree that pro-rate stage payments will be made if targets are partially achieved
- Ask one party to bear the other’s costs if they make an unsuccessful challenge
Earn out protections
When calculating the earn-out amount, the post-sale period is critical. Both the buyer and the seller should protect themselves against the company’s performance being artificially manipulated.
Earn-out period issues
The seller needs to make sure that the buyer manages the company in such a way that the risk of not meeting KPIs is minimised. For example, a seller may insist that the buyer doesn’t make material changes to the way the business is run, or veto certain decisions during the earn-out period, such as firing key staff or taking on too much debt. They might also insist that the buyer dedicates a sufficient budget to marketing and sales activity post-completion.
Seller’s involvement post-sale
If the seller stays on post-sale, the buyer should ensure they manage the business effectively during the earn-out period. They should also consider what will happen if the seller decides to leave before the end of the period.
Earn-out on asset purchases
You can also include an earn-out when an acquisition is structured as an asset purchase rather than a share sale, and apply the same reasoning when structuring the earn-out.
Earn-outs on the term sheet
The issues we’ve described in this guide apply equally when negotiating a term sheet. Be clear about your expectations, and make sure the document accurately reflects these.
In summary:
- Agree the KPIs used to calculate the earn-out amount
- Decide when the earn-out will be paid, and how it will be structured
- Agree how the KPIs will be measured and how disputes will be resolved
- Agree how the company will be managed post-sale, and whether there will be any restrictions on the activities of the company during the earn-out period
Earn-out alternatives
The buyer is usually in the driving seat when it comes to earn-outs. The usual reason for an earn-out is to bridge the gap between the seller and the buyer’s valuations. A buyer can also limit their risk by requiring the seller to stay on for a period to maximise value to the buyer.
There are several problems with earn-outs. Firstly, there’s a mismatch of interests where the seller remains in the business post-sale. The buyer in theory controls the company, but the seller needs some of that control to achieve the KPIs.
Secondly, the parties may manipulate the business post-sale, for example, the seller may drive down costs artificially to boost earnings, or the buyer inflates costs to decrease profits.
One alternative to an earn-out is a staggered purchase. The parties agree a valuation, the seller gets cash and shares on completion. The seller’s remaining shareholding are then sold to the buyer on a staged basis during a set period using put options. These are valued in using an agreed formula and exercisable on a staged basis.
Alternatively, you can use call options. The seller remains on the board of the company and can opt to exercise the options or remain working for the company. Equally, the buyer may choose not to exercise the call options and operate the business jointly with the seller.
For this kind of staggered arrangement to succeed, the seller and the buyer need to work closely together to manage the business post-sale. This way, the purchase price is less susceptible to manipulation by either side.
Earn-out seller protections
When an earn-out is based on future earnings, the interests of the buyer and seller are misaligned, post-sale. Should a buyer, for example, lose key customers, sell key assets, or otherwise take decisions that impact earnings, the value of the earn-out for the seller is reduced.
For this reason, the seller is often asked to remain in the business for a certain period to protect the buyer’s interests. Their service contract or employment agreement should contain terms that stop the buyer from interfering with the seller’s ability to meet the KPIs such as artificially reducing the marketing budget or cutting staffing levels.
Equally, if the seller is not going to stay on, the sale and purchase agreement should provide that the buyer can’t do anything that impacts revenue or profitability. The buyer might be asked to run the business in the same way as it operated pre-sale to maximise the chance of the earn-out target being achieved.
Our earn-out solicitors specialise in mergers and acquisitions (M&A) for start ups and high-growth businesses. Contact us now by filling out the enquiry form below or by phoning 0800 689 1700.
