Due to historically high inflation, severe personnel shortages in most industries, the war in Ukraine and the nitrogen crisis, times are currently uncertain. In acquisitions, we are therefore seeing earn-out arrangements being used more and more widely.
In this expert contribution, we address the questions: what is an earn-out and how does an earn-out arrangement work in a business acquisition?
What is an earn-out?
The literal translation of the term earn-out is "earning out," and within the context of a business acquisition, it means "earning afterwards. In the world of business acquisitions, an earn-out is a contractual mechanism that provides for a contingent (additional) payment, which is paid after the transfer of the business. In addition to the up-front payment, the earn-out constitutes the entirety of the purchase price.
The contingent payment refers to achieving a predetermined result, over a predetermined period of time. This is the core of an earn-out arrangement: based on a result to be achieved within a certain period, the final determination of (part of) the purchase price follows.
The outcome of an earn-out can be determined in many ways. Common is to contractually define a revenue, (gross) margin and/or operating result to be achieved. The result does not always have to be financial. An earn-out can also be contractually defined on the basis of staff retention, customers and/or completion of work in progress;
To make an earn-out measurable, the period within which the selling party must achieve the predetermined result is important. This could include a period of, say, a quarter, six months, a year or even longer or shorter.
How does an earn-out arrangement work?
An earn-out arrangement can provide a solution when the buyer and seller have a difference of opinion during negotiations about, for example, the purchase price, about achieving a budget or about setting a transfer period between the two parties during which a specified performance must be delivered.
With an earn-out arrangement, the purchase price is divided into a fixed portion (the up-front amount) and a variable portion (the earn-out). The fixed portion of the purchase price is paid by the buyer to the seller per transfer of the business.
The variable part - the earn-out - represents that part of the purchase price for which the seller is convinced that this result will be achieved, while the buyer, on the other hand, has its reservations about this and wants to limit this risk through the earn-out arrangement.
Example
The earn-out arrangement in the case of an impending personnel shortage in a transaction, could look like the following (Note: this example is for illustrative purposes only):
- During negotiations, the buying party expresses concerns about retaining staff after the transfer of the business;
- The seller demonstrates by means of personnel lists that there has been virtually no staff turnover in recent years. In doing so, the seller emphasizes that the staff is loyal to the business;
- The buyer and seller agree to contractually stipulate the retention of personnel after the transfer of the business in an earn-out arrangement;
- The parties agree to set the earn-out period (term) equal to the transfer period (say, for example, one year) between buyer and seller with the reference date set at the end of the earn-out term (say, for example, Dec. 31 of the year);
- The buyer pays per transfer date the fixed part of the purchase price corresponding to the agreed purchase price minus the variable part - the earn-out in this context. For the variable part, an amount x per employee (for example, suppose €15,000 per employee) multiplied by the number of staff employed on the transfer date is agreed upon as an earn-out;
- Given the labor market tightness and staff shortage of the buying party, the buyer and seller agree on an upside earn-out of the same amount for each additional employee hired as of the reference date;
- To flesh out the above, suppose:
- On the transfer date, there are 20 employees;
- The amount per employee is €15,000;
-The earn-out period is 1 year;
- The earn-out is set at €300,000;
- After one year, on December 31 of the earn-out period, 22 staff members are employed, of which 2 employees resigned and 4 additional employees were hired. The total earn-out is set at €330,000, of which the upside is an amount of €60,000 (4 times €15,000) and the variable part of the earn-out is €270,000 (2 times €15,000).
Points to consider
The starting point in the Dutch legal system for contracts is the principle of contractual freedom. This freedom of contract is based on "regulating law," which means that the legislator leaves it to the parties to arrange and agree on certain matters as they see fit.
In business acquisitions and entering into an earn-out arrangement, this means that parties are free to formulate an earn-out as they see fit regarding, for example, the content, form, with whom and with what definitions. The main exception to this freedom of contract is laid down in article 3:40 of the Civil Code. This stipulates that contracts are void if their content or operation is contrary to morality or public order.
Parties are therefore free to define and record an earn-out arrangement as they see fit, provided, however, that the provisions in the contract are legally permissible. Therefore, with an earn-out that is not clearly and measurably contractually defined, there is a risk that both the buyer and seller may have their own interpretation of the earn-out arrangement.
It is therefore recommended that an earn-out arrangement be drafted clearly, unambiguously and not open to multiple interpretations.
