Earn-Outs: The what, the why and the how

A key element for both the buyer and seller to consider when negotiating a share purchase agreement (SPA) is how to structure the consideration to pay for the target company. Options include a fixed cash sum at completion of the transaction with a price adjustment mechanism such as completion accounts with the possibility of deferred payments in addition to the initial consideration. One such deferred payment mechanism is an earn-out where the seller receives additional consideration on an agreed post-completion date or dates based on the future performance of the target. During uncertain economic times, as experienced in recent years, it can be difficult for a buyer to accurately predict the future performance of the target company which in turn can contribute to disagreements between the buyer and the seller on its true value. As a result, it seems that earn-outs have become increasingly popular because they can serve as a "bridge" between the buyer's and seller's price expectations by measuring the future performance of the target to help calculate its actual value.

Why use an earn-out?

An earn-out is a price adjustment mechanism usually involving a portion of the purchase price being paid at completion and leaving part of the consideration – the earn-out - to be calculated with reference to the post-completion performance of the target. An earn-out can also be used to determine the entire price of the target but this is less common. The earn-out payment is calculated by reference to an agreed performance metric such as sales, turnover or profits and these are assessed over a period of time, usually between 1 and 3 years following completion . The earn-out structure is flexible and can be adapted to fit the particular features of the deal and can provide certain advantages to both the buyer and seller. For example, it reduces the risk that the buyer overpays for the target and gives a seller some assurance that they are achieving full value for their shares/assets.

There are, however, also potential disadvantages to using earn-outs. They can be complex and expensive to negotiate and difficulties can arise when measuring the target's performance during its integration with the buyer's existing business.

The agreed earn-out mechanism will ultimately depend on factors such as the relative bargaining power of the parties, the availability of funds and tax considerations.

For a fuller explanation of earn-outs in general and other pricing structures, please see Brodies' earlier insight articles here and here.

A cautionary tale

Whilst earn-outs can be a pricing solution for both buyer and seller they are not always easy to operate in practice. One of the difficulties with earn-outs is illustrated by the 2011 English High Court case of Porton Capital Technology Funds v 3M UK Holdings Ltd.

Porton owned a company that had developed novel technology to screen for the antibiotic resistant bacteria MRSA. Porton agreed to sell the company to 3M pursuant to the terms of a SPA that contained an earn-out provision. The earn-out was to be calculated on the basis of sales during the first year after completion with the earn-out value potentially being for a sum of up to £41 million.

However, during the earn-out period 3M sought Porton's permission to cease development of the target's main product in the US and other markets citing a lack of prospects of achieving prompt regulatory approval and lower than expected sales. Porton refused consent, but notwithstanding this 3M still ceased the development of the MRSA product anyway. As recompense 3M offered a payment to Porton of a sum representing a fraction of the maximum earn-out payment. Porton raised an action against 3M for payments lost as a result of 3M's breach of the earn-out provisions. In response 3M contended that, among other matters, Porton had unreasonably withheld its consent to the cessation of part of the target business. The High Court found in favour of Porton and determined that 3M had breached its contractual earn-out obligations to seek regulatory approval for, and market the target company's MRSA product in the US and certain other markets. Porton was awarded US$1,299,808 in damages.

Whatever the merits of the conduct of each party, this case illustrates the potential pitfalls of using earn-outs. Even with well drafted agreements and good intentions, disputes can and do arise between parties with opposing interests and expectations. The case highlights not only the importance of careful consideration in the drafting of earn-outs, but also the inclusion of protections for both buyer and seller to help minimise risk in the event that things do go wrong.

How can an earn-out can operate to protect both buyer and seller?

The way in which the buyer conducts the business of the target post-acquisition will affect the earn-out value. To protect itself and the earn-out value the seller will therefore look to include provision in the SPA in relation to the extent of its and the buyer's management of the target company during the earn-out period.

There is likely to be benefit for both parties if the seller remains employed in the target business – the buyer will benefit from the seller's knowledge of the business and their motivation to ensure the success of the target company to maximise the earn-out value and the seller will benefit from being involved in the management of the target to ensure that the buyer does not make significant changes to the business or divert business elsewhere to the detriment of the earn-out value.

Consequently, to be agreeable to both parties, the earn-out provisions will have to balance the tension between the parties and their wish to restrict the freedom of the other to manage the target for their own aims.

How can Brodies 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 on both the buy side and the sell side. Should you require any further information, please get in touch with your usual Brodies contact.