A business acquisition is often a complicated process. There are major interests at stake, and buyer and seller have different expectations. In this process, determining the value of the company is a difficult task.
The seller looks to the past and sees a successful business with growth potential. The buyer mainly looks ahead and wonders whether those good figures will continue after the transfer. An earn-out arrangement can then offer a solution.
This is an arrangement in which part of the purchase price is made contingent on the future results or performance of the company after the acquisition. Such an arrangement can be a smart way to bridge the gap between the different expectations and interests of buyer and seller, but is certainly not without risks.
What is an earn-out arrangement?
In an earn-out, the seller does not receive the full purchase price upon transfer, but the buyer pays part of the purchase price later, depending on the results or performance of the company after the acquisition. For example, consider a minimum profit or revenue within a certain period after the acquisition. For the buyer, this is a way to mitigate risk, and for the seller, it provides the opportunity for a higher price if the business continues to perform well.
An earn-out is mainly applied when there is uncertainty about the future profitability of the company, the seller remains involved in the company after the acquisition or when buyer and seller have different expectations about the growth potential.
An earn-out can also help unblock stalled negotiations on the valuation of the company. At the same time, an earn-out requires trust and a good understanding between the parties and clear agreements.
Legal advantages
Spreading risk: The buyer only pays the full price if the business actually achieves the expected results.
Reward incentive for the seller: Especially if the seller stays on (temporarily), an earn-out stimulates commitment to a good result.
Flexibility in negotiations: It can make the deal possible when parties are still apart on valuation.
Legal disadvantages and points of attention
Discussion of the calculation: How are earn-outs measured? According to which accounting rules? What does or does not count?
Influence of the buyer: After the acquisition, the buyer determines the policy. What if he postpones investments, makes strategic changes, shifts revenues to other entities or allocates costs differently, resulting in lower profits?
Transparency and information duty: The seller often no longer has direct access to the figures, which makes it difficult to monitor the earn-out. Who monitors?
Tax aspects: The tax treatment of an earn-out can be complex for both buyer and seller.
Clear contractual agreements
The buyer is obliged to make an effort to actually make the earn-out agreements possible, and thus may not encourage the agreed goals to fail. What that means in concrete terms and what exactly can be expected from the buyer depends on what the buyer and seller have agreed together and what they can reasonably expect from each other.
So then it comes down to what the agreement says in concrete terms. Making clear agreements in advance about what buyer and seller can and cannot expect from each other is crucial. If this is not done, it is difficult for the seller to complain afterwards about the way the buyer runs the company and makes decisions that have a (negative) impact on the earn-out.
Case study
A family business in the metalworking industry is sold to a sector colleague. The agreed sales price is €2 million, with an earn-out of €500,000 on top if profits increase by 25% within two years. The founder - also the seller - stays on for another year as technical director, to properly transfer the staff and production.
After the acquisition, however, the buyer decides to halve the number of permanent employees and outsource part of the production to a sister company. There is also less investment in machinery and maintenance. As a result, the company's growth stagnates, and profits fall far short of the agreed-upon target.
The seller is disappointed and believes that the buyer has undermined the agreements made. The judge will then look at what exactly is in the purchase agreement. If nothing concrete is stipulated about staff retention, investments or production capacity, there is a good chance that an earn-out claim will be rejected.
With professional parties, it is assumed that they have a good understanding of what is and what is not in their agreement, and the court does not readily assume additional obligations that are not explicitly included. In this case, this means that the buyer acts within his contractual freedom and the seller is left empty-handed.
In short
An earn-out can be very valuable in business acquisitions. However, it is not a standard solution, but requires customization. Good legal guidance can ensure that all interests are properly considered, pitfalls are identified and agreements are carefully formulated. Clarity in advance prevents disappointment afterwards.
