Businesses can be notoriously hard to value, particularly if they are relatively new or operate in a fast-moving sector. When a business is up for sale, one way of resolving any differences between the buyer’s and seller’s opinion of its value is by using a technique called an earn out.
Earn outs can be a great way to get a stuck transaction moving again, or to facilitate a purchase where the buyer is struggling to find the necessary funds to complete. In essence, an earn out allows a buyer to offer a part-payment for the business at the time of the sale, and the remainder over time if it performs as expected. In an earn out, a seller may remain in the business for the earn out period.
While earn outs can be helpful, the mechanism by which the pay-out will be calculated can be tricky to draft, and post-sale disputes are quite common. This article looks at how earn outs work, examines common earn out structures and provides tips for negotiating your earn out.
- What is an earn out and what is its purpose?
- Deciding on whether an earn out is worth pursuing
- Key elements of an earn out agreement
- Type of agreement
- Performance targets
- Term of the earn out
- Distribution of earn out payments
- Earn out formula
- Earn out formula example
- Method or Form of Payment
- How to negotiate an earn out
- How to structure an earn out
What is an earn out and what is its purpose?
The purpose of an earn out is to reconcile differences of opinion as to the value of a company between the seller of that business and a buyer. This discrepancy is resolved by using a provision in the sales contract that allows the seller to claim additional money from the buyer if the business performs well after the sale. From the buyer’s perspective, they will pay a certain portion of the sales price up-front, and the remainder at some future date, provided the targets set in the contract are met.
The phrase ‘earn out’ is a catch-all expression used to describe any mechanism in the sales contract where the purchase price depends on how it performs after the sale has taken place. Often the earn out amount will be calculated by looking at the company’s profits post-sale, but other benchmarks can be used such as turnover, new customers gained or the volume of repeat customers. Sometimes payment of the purchase price will be staggered subject to the achievement of certain targets, and sometimes the instalments will be reduced pro-rata in relation to performance against targets.
Sellers and buyers of businesses often have a very hard time reaching agreement on the value of a company and disputes can arise. To find out more about how earn-outs are used as part of sale purchase agreements, the common causes of earn-out disputes and the steps to avoid them, see our article How do I avoid an earn-out dispute?
Deciding on whether an earn out is worth pursuing
If you are thinking of buying (or selling) a business, you may be having difficulty in coming up with a suitable valuation. In these cases, an earn out option may be worth pursuing. Here are some scenarios where it’s tricky to put a true value on a company:
- Where the company is a start-up, but it has very good prospects for growth.
- Where a company has developed a promising new product or service.
- Where a company has suffered a dip in revenues due to an unforeseen event (for example, COVID-19).
- Where the sector in which the company is operating is fast-moving and volatile.
If you are the purchaser, in addition to the factors above, you may be having trouble accessing funds to complete the sales transaction and an earn out will enable you to stagger payment of the purchase price.
An earn out is probably not worth pursuing where the buyer intends to transform the business after the sale, for example by merging its activities into their existing business. This is because in such cases the target business’s performance can be difficult to measure.
Either a buyer or a seller may benefit from an earn out. From the seller’s point of view, an earn out can help resolve any dispute about the business’s true value, and enable the seller to claim the full value of the company when it performs as they expected post-sale. In addition, if the buyer has existing activities or customers that will add value to the business being sold, an earn out will enable the seller to claim the value added to the sold business as a result.
An earn out can be worthwhile for a buyer where it enables them to put a true value on a company and not over-pay for it on completion. By staggering the payments over time, this can also help the buyer’s cash-flow, and they can use the company’s post-sale profits to fund payments of the earn out amount. If the seller stays on in the business for a period after the sale, an earn out can help the buyer ensure that they work hard during that period to maximise the company’s profits.
When deciding whether an earn out is worth pursuing, you need to consider certain disadvantages, for example:
- The potential for post-sale disputes.
- The fact that the seller may continue to work in the business post-sale and restrict the buyer’s ability to control the business’s operations.
- The fact that an earn out introduces a degree of uncertainty around how much will be paid for the business, and that the profitability of a business may be affected by external factors post-sale that have nothing to do with its intrinsic value.
- Drafting and negotiating earn out conditions can be costly and time-consuming.
- Monitoring post-sale performance can equally be time-consuming and a distraction from the business at hand.
- There may be tax disadvantages to buyer or seller by using an earn out.
Key elements of an earn out agreement
How an earn out is structured can be very flexible, and there are no hard and fast rules. The main elements include how any future pay-outs will be calculated, and whether the seller or their team will stay on working in the business post sale.
Here are some typical components of an earn out agreement:
- How long the earn out period will last.
- How the company’s performance will be measured and the earn out calculated.
- How disputes will be resolved.
- Whether the seller will continue to be involved in the company post sale.
- Whether the company and the buyer will be limited in terms of the things they are able to do post-sale that might affect the earn out amount.
Type of agreement
The terms and conditions that relate to the sale of a business are usually contained in a document called a share purchase agreement (where the sale is of a company limited by shares). The specific terms of the earn out will normally not be in the body of the SPA but in a schedule or annex to the agreement so that they can be drafted and negotiated separately, and are easily accessible since they will need to be referenced after completion has taken place.
The amount of an earn out can vary according to certain targets for company performance or other benchmarks. Usually these targets or benchmarks are financial in nature, and may include the company’s profits, earnings, revenues, or income.
When thinking about an earn out from the seller’s perspective, it’s often preferable to go for a performance target that’s tied to revenues, because it’s possible for a buyer to artificially deflate profits by increasing costs and expenses. In the case of start-up or fledgling businesses, it’s sometimes better to use a non-financial measure because of a lack of historical financial data. In these cases, you can use instead targets based on the number of new customers or the volume of sales.
Whatever methodology you use in defining performance, it’s important to use experienced corporate lawyers and accountants to help you draft the earn out clauses, and define the accounting principles and treatments to be given to certain items such as how profits will be calculated, and how to deal with extraordinary items like windfalls.
Term of the earn out
How long an earn out period will last depends on a number of factors such as the payment schedule and calculations, and whether the seller will continue to be involved in the business post-sale. A short earn out period is normally better for both buyers and sellers as it reduces uncertainty and risk for both sides. However, a buyer may prefer a longer earn out period where it needs to raise funds to make the earn out payments, and the seller may prefer a longer earn out period where it intends to stay on in the business to maximise profits and thus increase the eventual purchase price.
Because the performance of the company being sold is key to determining the amount of the earn out payment, how the business is operated post-sale is crucially important. For that reason, sellers often want to remain involved in the company during the earn out period, or at least restrict the buyer in terms of how they operate the company. For example, a seller might ask the buyer not to make major changes in the way the company is run, insist that the buyer provides appropriate support to the company so that it can realise its earnings potential, and ensure that the buyer doesn’t do anything that might artificially distort the company’s profits and earnings.
Often, this motivation of sellers to restrict buyers in their post-sale activities manifests in the seller staying with the company after the sale as an employee to help with the transition to a new owner and to ensure that the company is properly run so as to maximise the seller’s earn out rewards. This might also involve non-compete clauses so that the seller is not able to set up a rival business during the earn out period.
Distribution of earn out payments
The way that earn out payments are staggered can be highly variable. There may be a short earn out period, with a single payment at the end. Alternatively, there may be a number of milestones over years, with multiple payments during the earn out period.
Earn out formula
An earn out formula can contain a number of components and factors.
The earn out formula may state that the purchase price will be divided into fixed stage-payments that will be made if targets are achieved. There may also be a formula to vary the amount of the stage-payments over time.
Alternatively, stage-payments may be variable, and increase or decrease in line with performance, for example by multiplying the amount by which performance has exceeded expectations, or by being calculated with reference to a percentage of profits.
If a formula is used for stage-payments, it may be appropriate to include a cap on the amount that the buyer will pay, and from the seller’s perspective, negotiate a minimum price that the seller will receive.
Earn out formula example
A company has £100,000 in annual revenues with £10,000 of profits. The buyer would be prepared to pay £50,000 for the company, but the seller thinks that this figure under-estimates the company’s potential for future growth. It suggests a purchase price of £100,000. An earn out is agreed where the buyer pays £50,000 on completion, and a further payment of £50,000 over three years if the company reaches certain sales and profits targets, and less if the company doesn’t perform as the seller anticipates.
Method or Form of Payment
Normally a buyer will pay the seller in cash, but they may also offer shares in the buyer, or loan notes. If the seller is worried that the buyer may not be able to pay the earn out amounts in the future, they have various options including a bank guarantee, demanding that funds be put in escrow, or by asking for some kind of security from the buyer.
How to negotiate an earn out
In uncertain times, it’s very hard to put a value on any business. And when a seller and buyer fail to agree a price, it’s easy for a transaction to collapse under the weight of each side’s expectations. An earn out is a relatively simple way to balance the needs and expectations of both buyer and seller and enable a deal to complete. For both buyer and seller, it’s important to bear in mind the following factors:
- The dynamic of the business will likely change post-completion, and after integration with the seller’s business. For example, the buyer may be able to realise economies of scale and of scope that might increase profits and reduce costs. You should think about these factors pre-completion.
- If the buyer might want to sell the company after the sale, or otherwise merge it into its existing business, this may complicate the earn out formula. How might a future sale affect this?
How to structure an earn out
As we’ve seen, there’s no hard-and-fast rule in terms of structuring an earn out. There are some issues however that need to be addressed if this is an option you are considering:
- You need to be clear and explicit in the document how the performance measures and earn out amounts will be calculated.
- You need to ensure that you have a dispute resolution procedure baked in to the documents that you can use if disagreements arise.
- You need to agree what accounting methods will be used when the earn out amount is calculated.
- You need to figure out how the seller will be involved in the company post-sale and how the company’s activities might be restricted.
One golden rule applies to earn outs, and that’s to keep it simple. You need to remember that the objective of any earn out is to provide an incentive to the seller to maximise the sale price by keeping up the company’s performance. The more complex the earn out formulae are, the more potential there is for disputes.
The greatest insurance you can offer yourself against future disputes is to use a qualified and expert solicitor to guide you through the sale and earn out process, and drive towards a simple deal based on easy-to-measure benchmarks.
- Who will run the company after the sale? Can you keep the seller on board for a time so that growth objectives are realised?
- Keeping the earn out period as short as possible for the benefit of both sides.
- For the seller, make sure you have some degree of control over the buyer’s operation of the company you’ve just sold.
- Make sure the earn out financial incentives are sufficient to keep both sides motivated.
- How disputes will be dealt with as painlessly as possible.