An earn-out arrangement is one in which payment by a party is contingent on future results. In other words, payment follows only when a certain future performance is achieved. If this performance is not or partially achieved, nothing or less has to be paid.
The main reason for agreeing on part of the transaction in the form of an earn-out is uncertainty about the future. Consequently, in the current unruly years, we are seeing an increase in the use of these arrangements.
The disagreement about the future may not only have to do with industry conditions, but it may also be that buyer and seller assess them quite differently. If the buyer is still willing to pay (more) if the seller's higher expectations come true, then an earn-out arrangement may offer an opportunity to come to an agreement. In some cases, this may even be the only way to come to an agreement.
Financing the transaction can also be a reason to agree on an earn-out. By pushing a part into the future and only paying when certain results are realized, this can improve the financeability of the acquisition.
Earn-out: part of the transaction sum
As far as we are concerned, an earn-out arrangement should apply to a limited part of the transaction sum, because it is a healthy thing that when shares change hands the entrepreneurial risk also passes from seller to buyer. In addition, a buyer usually gains control over the company and can thus (negatively) influence the outcome of the earn-out, while the seller can hardly do so. Therefore, a limited portion of the transaction sum is preferably structured in this way.
A good commitment
In practice, an earn-out arrangement often leads to discussions that can be partially avoided by taking a number of things into account:
The business should be continued in the same way.
Arrangements should also be made so that new customers and the resulting revenue, also come into the sold company. If there is a strategic buyer, they will usually not want to wait too long to integrate the purchased business with the existing business, for example to achieve cost savings. However, in order to properly assess whether the agreed results have been achieved, integration during the term of an earn-out will make this assessment more difficult.
Make clear agreements that can be easily monitored by both parties.
In practice, this means, there is a preference to agree key performance indicators "as high as possible in the income statement. Net profit is affected by many factors, while revenue is much less so and therefore a better basis for an earn-out agreement. This is what is meant by 'as high as possible in the income statement'.
The term should not be too long, preferably a maximum of three years.
The business is moving on and the distance with the seller will quickly increase, making the arrangements more difficult to follow as time passes.
Critical comment
Although an earn-out arrangement can be a solution (sometimes the only solution) we certainly do not want to deny that an earn-out arrangement often leads to discussions between parties. The main disadvantage is the fact that buyer and seller sometimes remain linked for a long time. The buyer can thus feel restricted in his entrepreneurship and the interference of a former owner can also cause irritations.
