Until about two years ago, interest rates were low, the economy was miraculously recovering from the corona crisis and we were not yet dealing with the negative consequences of the Russian invasion of Ukraine. All positive developments for the takeover market.
For some time, however, we have seen a very different trend. There are many uncertainties in the current economy, interest rates continue to rise and the number of deals is creeping back. The market is tilting more and more from a seller's market to a buyer's market.
This shift is also reflected in deal terms, such as the increase in the maximum amount for which the seller can be held liable and the increasing use of earn-out arrangements. We dwell on the latter in this expert contribution.
Earn-out
The earn-out arrangement is a very useful tool to get a deal done if the buyer and seller cannot agree on the purchase price. We still see most sellers stuck in the higher valuations of two years ago, while buyers see more and more uncertainties in the future. This creates a split between the expectations of both parties.
The earn-out arrangement can then offer the solution, as the seller receives a variable part in addition to a fixed part of the purchase price. This allows the seller to eventually receive the desired (higher) purchase price, while the buyer limits the risk for himself because the variable part depends on future performance. The earn-out is then (often) paid from the operation, so the buyer does not have to finance the entire purchase price at once at the unfavorable conditions in the current market.
Fodder for discussion
Once the buyer and seller want to go for an earn-out arrangement, it is then important to make clear agreements about it. After all, an unclear earn-out arrangement is fodder for discussion later on.
One of the concerns with the earn-out arrangement is that proper agreements must be made about the parameters used to determine whether the earn-out should be paid. Parties often agree on financial parameters, such as revenue, (gross) profit or EBITDA.
When choosing the financial parameter, it is necessary to assess carefully which one is most appropriate for the target (company being acquired). No single parameter is necessarily right or wrong. The seller will often prefer the revenue-based earn-out because revenue is less susceptible to manipulation by the buyer. The buyer, on the other hand, will want to negotiate an earn-out based on profit-based parameters.
Clear agreements
Whatever parameter is chosen, it is ultimately essential that clear and unambiguous agreements are made about it in the SPA (Share Purchase Agreement). Make sure that the method of calculating the earn-out is specifically included. Especially if the chosen parameter is open to multiple explanations from an accounting point of view. This can especially occur if the deal is concluded between international parties, where there are also differences in accounting standards between the countries where the buyer and seller are located.
Furthermore, it is also possible to agree on "a sliding scale" for payment of the earn-out rather than an all-or-nothing construction if future target performance is or is not met.
Term
Finally, it is wise to pay attention to the period after the deal. At the very least, agree on a specific time period for the earn-out (usually from one to three years). Since the earn-out depends on performance, it is also wise to make contractual arrangements that require the buyer to continue the target's business in the usual way and on arm's length terms (including with buyer's affiliates) and to inform the seller during the earn-out period.
Ultimately, negotiations will have to balance the terms of the earn-out.
