Loading ...
Resources for Sound Business Decisions.™

Earn-Outs Agreements: Part 2 – Possible Outcomes

Note to the Reader: This is the second in a series of articles that explore the definition, application and issues of including earn-outs in negotiated M&A transactions.

An earn-out is an opportunity for both buyer and seller to maximize their respective post-acquisition returns on investment, but it doesn’t always play out that way. Generally, there are eight possible outcomes when an earn-out is included in an M&A transaction. This article provides an overview of the spectrum of possible outcomes and the significance to the buyer and seller:

  1. Success: The seller hits all or most of the performance targets and receives the payment as expected—on-time in accordance with the terms and spirit of the earn-out agreement. In addition, the hitting of the performance targets creates additional value and cash flow for the buyer. This is the most desired outcome, one that you can call successful.
  2. Partial Success: The seller can hit a portion of the performance targets and receives a payment that is disappointingly lower, but both buyer and seller believe that the earn-out was implemented faithfully and that each party gave an honest best effort. While this is not the optimal outcome, it is still successful.
  3. No Success, but No Foul: The seller misses the performance targets and doesn’t receive any payment, but both the buyer and seller believe that the game was played fairly on a level field. There is no cause for celebration. The players feel that they faithfully tried to adhere to the letter and spirit of the agreement and both parties walk away amiably, but disappointed.
  4. Mid-Flight Change: There are a number of business events that can present themselves during the term of an earn-out agreement that can create problems. Examples include termination of the seller’s employment (if employed), the sale, assignment or transfer of the business unit or company, and termination of the buyer’s management team. To the extent that these issues have been diligently addressed in the earn-out agreement, the change can be smooth. If not, then we move to the next two possible outcomes, a controversy or a fight.
  5. Controversy: The seller doesn’t earn a payment or earns one that is lower than expected and feels that the agreement was implemented in bad faith. The seller may believe that his or her ability to earn the payment was thwarted by the actions of the buyer. It is also possible that the seller earned a payment but it was withheld or used to offset a charge arising from the provisions of another transaction agreement. In this outcome, the earn-out results in a controversy that can mushroom into a full-fledged fight. In both instances the buyer and his or her legal team need to get into conflict-resolution mode to contain the situation. This is a poor outcome and the only question is: will it be contained.
  6. Failure and a Fight: When there is a controversy that can’t be amiably resolved, the conflict can escalate into a legal action. This is the worst outcome and one that will cost the parties a considerable amount of stress, time and money. This risk can be mitigated by building a conflict resolution process into the agreement.
  7. The Wrong Target Gets Hit: It is possible that the seller successfully hits all or part of the performance targets and it doesn’t create additional cash flow or value for the buyer. This could be due to the selection of the wrong performance targets or a malformed agreement. In this case, the seller is being paid directly out of the buyer’s pocket, which is a big disappointment because the buyer was assuming that the seller would only be paid if the deal was successful.
  8. The Big Surprise—the Unknowable Unknown: Life doesn’t fit into a projection and it doesn’t much pay attention to statistics and bell curves. Unexpected random events can lay waste to the best formed plans. Nassim Taleb’s Black Swans are in some invisible or ignored corner of our Universe doing push-ups. There are positive surprises and then there are surprises that bring misfortune. As a buyer, it never hurts to spend some time trying to imagine the unimaginable.

Negotiating a careful and comprehensive earn-out agreement is time intensive and incurs legal, tax and accounting fees for both buyer and seller. So, before a buyer embarks upon the path of including an earn-out as part of a buy-out, be sure that it is really a good idea.

Next Edition: Part three in this series of articles will provide a framework for evaluating whether an earn-out makes sense in a particular transaction and outlines the elements for negotiating one that maximizes value and mitigates risk from the perspective of a business buyer.