An earn-out is a deferred payment based on the post-completion performance of the target company.

The earn-out is normally calculated with reference to the target company’s profits over a period post completion, but may be linked to other financial or operational benchmarks, such as turnover, net assets or number of products sold.

Why use an ‘Earn-out’?

The following reasons may merit using an earn-out in a transaction:

• Market Risk – if a market is potentially unpredictable, the sellers and buyers share the risk of the future success of the business.
• Incentivisation – an earn-out could be used to try and persuade the directors/management of the selling company to stay and keep progressing the business.
• Costs – the buyer may want to defer part of the purchase price and make it contingent on the success of the target company.  

From a sellers’ perspective, potential benefits may include:

• Allowing the seller to obtain a fair price for selling a profitable business. Without the earn-out, the initial purchase price may be discounted due to the market risk (and other factors).
• If the buyer is a larger, multinational corporation, it may have access to greater resources, client base and other factors which could enable the selling company to reach its performance targets and generate a larger purchase price (ultimately) for the seller.

Potential benefits for a buyer include:

• Being able to ensure a more accurate valuation of the selling company, thus protecting the buyer from overpayment. Depending on the structure of the earn-out, significant amounts of uncertainty can be removed for the buyer if the earn-out is based on future performance, instead of past performance.
• If some of the management or other staff are key to the selling company’s operations, they could be incentivised to stay on and maximise the potential of the business, and help with integration.

General points to consider include:

• If there is an earn-out as part of the sale of their business, the seller may retain a significant interest in the day-to-day operations of the business going forward, and will not achieve a ‘clean break’ from it. For sellers approaching retirement, this is a key consideration.
• As the earn-out will likely depend on the selling company’s performance over the relevant period, monitoring and measuring of this can be costly as well as time consuming for the buyer.

Documenting the Earn-out

The terms of an earn-out arrangement will traditionally be included in the share purchase agreement for the transaction.

Whilst the provisions in the share purchase agreement will reflect the circumstances and goals of the parties, there are a number of key issues to consider, including:

• Time period – how long is the earn-out period? When must each financial milestone be met?
• Financials – what are the relevant performance indicators? The minimum and maximum payments per financial milestone?
  • Earnouts are typically structured so that EBITDA (earnings before interest, tax, depreciation, and amortisation), gross revenues, or gross profits milestones need to be met. Buyers will often prefer an EBITDA milestone, arguing that it will be the most reliable indicator of the value and profitability of the business.
• Sellers’ continuing rights and obligations (if any) relating to the management of the selling company throughout the earn-out period.
• Restrictions on the selling company (if any) during the earn-out period that could definitely affect the earn-out in any way.

If you or your business require information regarding anything in this blog or generally about your business or any other corporate matter, please call Sarah Ward, head of our corporate team, on 07889 589596 or e-mail Sarah at sward@georgegreen.co.uk for advice and assistance.