Earn-Out Agreements: Part 5 – Key Negotiating Points
Note to the Reader: This is the fifth in a series of articles that explore the definition, application and issues of including earn-outs in negotiated M&A transactions.
When a buyer and seller approach the negotiation of an earn-out, they have a common goal of arriving at an agreement that meets their respective needs. It is reasonable that both buyer and seller will want to negotiate a deal that meets their respective financial objectives.
While the buyer and seller may have different negotiating strengths, weaknesses and skills, each party wants a bargain that minimizes their risk by shifting as much of it as possible to the opposing party. This sets up the dynamic tension in which negotiations take place.
This article is written from the buyer’s point of view. It examines the key terms of an earn-out that will need to be ironed out. In addition, this article assumes that the buyer and seller have:
- Identified the value gap along with its reasons.
- Decided that an earn-out is something worth pursuing.
- Defined the business activities that are associated with the earn-out.
- Reached a tentative understanding of the seller’s post-closing obligations.
As a buyer approaches the details of negotiating an earn-out, there are two questions to keep in the back of his or her mind:
- What are the buyer’s business objectives? In general terms, an earn-out is a way to bridge the value gap between buyer and seller. It can also serve as a form of acquisition currency. An earn-out can help maximize the value of the buyer’s investment. These are generalities. As a buyer, you want to drill down into the specific objectives of what you want to accomplish through the earn-out.
- What specific behaviors do you want from the seller? An earn-out can be structured so that the seller has an active or passive role in the business after the date of closing. An earn-out can provide an incentive for the seller to assume a predefined role in the operation of the business in order to achieve the agreed-upon performance target. The desired behaviors will define the future duties and responsibilities of the seller going forward.
In order to achieve maximum value from the earn-out, it behooves a buyer to negotiate a structure that aligns the buyer’s business objectives with the incentives provided to the seller. As you work your way through the business terms of an earn-out, you want to make sure that objectives and incentives are in full alignment. You want objectives and incentives to be congruent. Failure to align objectives with incentives can harm future value and create conflicts that can become distracting and expensive to resolve.
While there are many points that will need to be addressed in order to finalize a definitive earn-out agreement, its economic core consists of the following key elements that we call the “earn-out package”:
- Type of Agreement
- Performance Target.
- Term of the Earn-Out.
- Earn-Out Formula.
- Distribution of Earn-Out Payments.
- Method or Form of Payment.
Because of the complexity and dynamics of an earn-out agreement, it is essential that both buyer and seller obtain the advice of legal, accounting and tax professionals that are experienced with earn-out transactions. As a business buyer (individual, financial or corporate) or advisor, there are a number of fundamental issues that frame the negotiations of an earn-out package:
- Type of Agreement: In a business acquisition, an earn-out is the part of the consideration paid to the Seller that is contingent upon the attainment of a performance target or event. An earn-out can be included as a clause in the Purchase Agreement or set forth in a separate agreement.There are different ways to form an earn-out including:
- An earn-out clause and related terms in an Asset or Stock Purchase Agreement that makes a portion of the purchase price contingent upon meeting the performance target.
- License Agreement and/or Royalty Agreement can provide deferred and conditional consideration to the seller that is derived from the use of specified intellectual property.
- Commission Agreement that provides a percentage of sales revenues generated from specific product lines or customers.
- Bonus clause in an Employment Agreement that provides for a lump sum or percentage of a performance metric upon attainment a predefined objective.
- The type of agreement is important because it can have a significant tax impact for both the buyer and seller:
- Depending upon how the earn-out is structured, payments made by the buyer might be expensed, amortized or treated as part of the buyer’s basis.
- From the seller’s perspective, the structure of the earn-out could result in ordinary income or capital gains. This is an area that requires the expertise of experienced legal, accounting and tax professionals.
- Performance Target: The performance target sets forth the metric that needs to be achieved in order for the earn-out to be “earned.” The performance target can be tied to revenues, margins or profits. In some cases, the target can be defined as the completion of a project or attainment of a business objective.From a business perspective, there are four things to keep in mind when establishing a performance target:
- It needs to be specifically aligned with the buyer’s return on investment objectives. The appropriate metric is the one that works for both buyer and seller. For example, an earn-out based upon sales revenues may be desirable for the seller, but if the increase in revenues doesn’t correlate to an increase in earnings, the earn-out payment may be dilutive.
- The performance target should be clear and understandable.
- The greater the degree of complexity or variables involved in the calculation of the performance target, the greater the potential for misunderstanding.
- It is possible to have multiple performance targets, each associated with a different payout formula and rate.
- Term of the Earn-Out: There is a beginning and ending date to the seller’s eligibility to make their earn-out. The length of that period should be reasonably sufficient for the seller to reach the performance objective and allow the buyer to achieve the anticipated return on investment.A long-term agreement means that the seller and buyer are going to have a long-term relationship. A buyer needs to ask himself if this is something he wants.
- Earn-Out Formula: When the performance target is hit, the earn-out payment becomes “earned” and payable subject to the earn-out formula. The earn-out formula can include a:
- Lump-sum amount.
- Percentage of the performance target.
- Minimum amount plus a percentage of the performance target.
- Ceiling or cap on the amount earned during any one period.
- Ceiling or cap of the total amount earned over the term of the agreement.
The Earn-Out Formula sets forth the conditions and amount of the earn-out for any given period of time. The fact that a seller has successfully achieved their earn-out for a given period does not necessarily imply that a payment will be distributed. The agreement will guide the timing of payments and the manner in which specific payments are calculated.
- Distribution of Earn-Out Payments: There can be one formula for determining the amount of an earn-out that has been earned and another that directs how the earn-out is distributed. Depending upon the type of earn-out agreement, payments can be made monthly, quarterly, or annually. In addition, payments can be made at the end of the agreement’s term along with periodic payments. The information required to calculate the earn-out based upon the formula needs to be available. Therefore, the buyer will need a reasonable amount of time to gather the necessary data.An earn-out agreement can provide for simple periodic payments without recourse. Another option is to create an earn-out pool. This pool is more or less a cumulative account showing the amounts earned, distributions in a given period and a running total of payments.As an added protection, a buyer may negotiate a right to set-off losses against any future earn-out payments. In this way, losses in one year can be used to reduce the balance of the pool and the net amount paid to the seller over the term of the earn-out. (This right to set-off can also apply to deficiencies or breach of the agreement by the seller.)
- Method or Form of Payment: Since the seller has already deferred the earn-out payment and shouldered the risk of not meeting the performance target, earn-outs are often payable in cash. However, there may be occasions when the earn-out payment is distributed as a note payable or in stock.Using stock (or rights to equity) as well as note(s) as a currency for earn-out payments raises a number of potentially gnarly issues. The buyer’s legal counsel will want to make certain that any stock transferred conforms to applicable State or Federal Securities Laws and Regulations. In addition, there are the problems of the valuation and shareholder rights pertaining to such stock or equity, especially in a privately held company.While not particularly interesting to most sellers, paying an earn-out by issuing a note sounds very attractive to a buyer. Not only would the future payment to the seller be contingent upon a definition of success (performance target), but then after the payment is earned, the seller finances the payment. Outside of special situations, some sellers might respond to such an offer as an insult and as an indication that the buyer isn’t serious.
The above six points address the aspects of an earn-out package that impact return on investment. There are other issues that will need to be address by the legal team of the buyer and seller such as accounting definitions, inspection and audit of buyer’s books, conflict resolution, remedies in the event of breach, and other essential points that the advisors will want to cover.
As negotiations with the seller unfold, the buyer will want to input the key assumptions into their financial model to make certain that the net impact is neutral or favorable to the bottom line and return on investment. The type of agreement, performance target, earn-out term, earn-out formula, distribution and form of payment will all impact the amount, timing and tax consequence of the anticipated future cash flows. The amount and timing of cash flows will determine the return on investment and whether the Internal Rate of Return meets the buyer’s threshold or hurdle rate given the specific risk of the acquisition.