Earn-Out Agreements: Part 1 – An Overview
An earn-out can allow an otherwise willing buyer and seller to bridge the gap in their respective valuation concepts for the business in order to complete a sale. In periods of economic and political uncertainty, earn-outs seem especially attractive because they can help get deals done in a difficult business climate.
Recently, one adviser gave his audience this advice: Keep your cash. If you’re going to buy a business in this uncertain economy, do it with an earn-out. This may or may not be sound advice, but it certainly reflects an increased interest in earn-outs.
In a typical earn-out scenario, a seller may have a more optimistic view of the future earnings of the business, characterized by a conviction that their investment and labor in the business is about to bear an abundance of fruit. The buyer may understand the basis for the seller’s optimism, but is not convinced that results will materialize and doesn’t want to plunk down hard cash for what is essentially a riskier tranche of projected earnings. So, in certain cases, an earn-out agreement can be structured to bridge the value gap and to allow the buyer and seller to reach a meeting of the minds.
An earn-out can be used as an acquisition currency and as an incentive to encourage the seller who remains with the business after the sale to achieve the mutually agreed upon performance targets. Since the payment is only due upon attainment of the performance target, the advantages to a buyer include:
- Conservation of cash.
- Reduction of leverage (which is helpful in a tight credit market with typically lower advance rates).
- An incentive for the seller to make the transition in ownership a success.
- An overall reduction of risk.
From the seller’s vantage point, an earn-out represents an opportunity. If performance targets are hit, the seller receives additional value from the sale. If the company exceeds the performance targets, the seller may actually net more dollars in the long run. However, an earn-out is a risky proposition for a seller with the worst-case scenario being a complete failure to achieve the performance targets and not receiving a dime. In effect, risk is shifted by the buyer to the seller.
A Closer Look at the Definition of an Earn-Out Agreement:
An earn-out is a type of contingent payment. It is paid by a business buyer to the seller upon the attainment of certain predefined post-closing events (performance targets). An earn-out is one form of a contingency payment. While an earn-out is a contingent payment, it is not a Purchase Price Adjustment such as the ones made to reflect the actual values of balance sheet items as of the closing date.
The performance targets can be financial metrics (i.e., Net Revenues, Gross Margin, Net Operating Income, EBITDA, EBIT, EBT or NAT). A performance target can also be established in operational or project-based terms such as the completion of a research project, getting a production line or facility online, or closing of a specific sale.
Payments become due and payable when the contractually defined performance targets have been achieved. Payments can be made based upon a percentage of the performance target or as a lump sum. If performance targets are missed, then the amount payable to the seller is reduced according to the formula defined in the agreement.
The payments received by the seller under an earn-out are additional consideration and can be paid with cash or stock. If the payments are made in stock and an interest rate is not built into the agreement, it is possible that the IRS may impute interest.
A “reverse earn-out” is a variation on the concept. Under this arrangement, the buyer is paid an agreed upon amount or percentage of the performance target. The payment is reduced if the target is missed.
From a psychological perspective, in a reverse earn-out, a seller is working to “keep” the earn-out amount by achieving the performance target and will be “penalized” for missing the mark. In a normal earn-out, the seller is working toward a target so that he will “be in the money.” It is human nature to work harder to keep what we have rather than achieve something we don’t.
The higher an earn-out (as a percentage of the total consideration), the more committed the seller may be to seeing a payday. In addition, the larger the earn-out (as a percent of the total consideration), the higher the litigation risk in the event the seller feels that they were “shorted” by the buyer.
Earn-outs are not magic bullets. One-size-fits-all and cookie-cutter agreements are an invitation to disaster. Diligent and careful negotiations are necessary to resolve the stress points to reach an agreement that will hold together after the closing.
An earn-out presents additional risks and costs to the buyer and seller. It takes time to negotiate, draft, and implement an earn-out. There is also the risk of litigation. An earn-out can impose additional accounting and audit costs on the buyer.
An earn-out can reduce a buyer’s initial investment, bridge the value gap and provide an incentive for the seller. For the value-oriented negotiator, the primary objective of an earn-out is the maximization of value for both the buyer and the seller.
Earn-outs are commonly used when the buyer and seller are both interested in consummating a deal and need to bridge the value gap such as in the following instances:
- Businesses in the development or entrepreneurial stage with limited operating history.
- Companies that have introduced a new product line or technology that do not have a track record as of the date of negotiations.
- Turnaround situations in which the future existence of a business is in question. The focus is on survival and the business may not be generating positive cash flow.
- Markets or industry sectors that are experiencing growing valuation multiples that may be reaching a peak.
- As an incentive to keep the seller involved in the operations after the deal closes and the buyer wants the seller to have some “skin in the game.”
- Privately owned businesses where the owner’s concept of value is based upon projections that are more optimistic than the projections made by the buyer.
- A “value buyer” wants to acquire a business but is unable or unwilling to pay the entire price in hard money. This is especially helpful when negotiating with a seller that is under some pressure to sell.
Conceptually (but not legally), an earn-out is very much like either a bonus or a dividend. It is an incentive to meet a target. If the seller is going to have hands-on authority to hit the performance targets, it is more like a performance bonus. On the other hand, if the seller is going to have a passive or subordinate role, the earn-out payment is much like a dividend.
What looks like a “win-win” solution can turn into a litigious nightmare if the earn-out agreement is poorly drafted or implemented. An earn-out is not monopoly money. And, what looks like a marriage made in heaven, can quickly turn into a legal controversy. Then again, a carefully constructed and diligently drafted earn-out agreement can create value for both the buyer and seller while mitigating the risks.
The best advice for anyone considering an earn-out is to retain the services of an attorney with extensive earn-out experience. They will be able to guide you past the landmines and structure an agreement that supports your business intent and personal motivations.
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