Earn-outs - how to secure the best price for a company in M&A transactions?

What is an earn-out?

An earn-out is a price adjustment mechanism in M&A transactions found in the Share Purchase Agreement. The earn-out structure is flexible and can be adapted to fit the particular features of the deal.

It usually involves the buyer paying a proportion of the purchase price at completion with a further payment to the seller being made depending on the financial performance of the target in the post-completion period.

Which M&A transactions are likely to include an earn-out?

Earn-outs are most common in deals where the buyer and the seller cannot agree on the likely future performance of the target. These often involve technological, pharmaceutical and medical companies. It can also be used in the acquisitions of start-up companies as it is difficult to make a valuation of a start-up.

The buyer might want to protect themselves against overpaying for a new company which doesn't end up growing and developing in the direction that the original owners anticipated.

In any type of transaction, both seller and buyer must weigh up the advantages and disadvantages of using an earn-out, as covered below.

What are the benefits of using an earn-out for the buyer?

• An earn-out reduces the uncertainty and risk in relation to a number of issues including:
  • the valuation of the target company;
  • uncertain economic and political developments;
  • the target entering new markets with a recently invented product;
  • limited historical information available to the buyer about the target;
  • volatility of the market in which the target operates;
  • recent fall in the target's earnings; and
  • recent changes in the target, such as restructuring or changes to the target board.

• The true future performance of the target and not the anticipated future performance of the company on completion will dictate the price (or at least part of it) for the target. This can significantly reduce risk for the buyer when investing in and trying to estimate the future performance of the target.
• If the buyer doesn't have sufficient funding to pay for the target in full at completion, the earn-out period will defer part of the payment for the target. Deferring payment of the consideration in full may reduce the buyer's need to obtain third party financing for the deal, which may be of benefit when credit is not easily available.
• It can incentivise the sellers to remain in the business and to perform to the best of their abilities.

What are the benefits of using an earn-out for the seller?

A key benefit of using an earn-out is that the parties can progress negotiations without agreeing the final value of the target company.

If the target is a profitable business with substantial growth potential, using an earn-out gives the seller the chance to realise a higher price for the target. The true value of the company will be demonstrated in the earn-out period and the final price paid by the buyer should not be discounted for the risk of not achieving the hoped for future performance of the target.

The expertise and existing business of the buyer and the seller is combined during the earn-out period allowing the sellers to benefit from any resulting synergies.

What are the disadvantages of using an earn-out?

Earn-outs can be difficult to structure and there are costs associated with its negotiation. The constant monitoring of and fluctuation in the profitability or turnover of the target can increase the possibility of disputes between the parties.

It can be complex to measure the earn-out during integration of the buyer's and seller's businesses. The earn-out does not allow for a 'clean break' at completion and the seller will want to have some form of protection as to how the business is run post-completion. The operation of the earn-out can be subject to manipulation, especially if based on profits and so it requires careful drafting in addition to an element of good faith from both parties to be a successful price adjustment mechanism.

How to negotiate an earn-out?

When negotiating the earn-out structure, it is important to choose the relevant benchmark against which the earn-out will be calculated, which can be based on:

• the target's future profits;
• its future turnover;
• the value of the target's new net assets;
• the number of new customers gained in the earn-out period; and/or
• the number of products sold in the earn-out period.

The earn-out provisions in the Share Purchase Agreement should also cover the following points:

• the time period of the earn-out (usually 1-3 years);
• the frequency and method of payment of the deferred consideration;
• tax implications of using an earn-out;
• dispute resolution mechanism for any disputes about the future performance of the target;
• the extent of integration between the buyer and the seller in the earn-out period; and
• restrictions on the target in relation to trade or investment during the earn-out.

How Brodies can help

Brodies has extensive experience in handling UK and international M&A transactions (involving both share and asset sales) and we regularly advise our clients on transaction pricing structures, such as earn-outs.

Should you require any further information, please get in touch with your usual Brodies contact.