Earn-out provisions are a common part of mergers and acquisitions. In particular, they are used to bridge the gap between the buyer and seller when they value the future results of the target differently.
In addition, an earn-out can motivate the seller who stays on after the transfer to continue to make a good commitment to the company. Despite the best intentions of the parties, in practice the earn-out arrangement often leads to discussions and conflicts. In this article, I discuss a number of important aspects to consider when structuring earn-out provisions.
Provide clear measure
The purchase agreement should contain a clear definition about the yardstick by which future results will be measured. This prevents ambiguity about how the earn-out will be calculated. The measures are usually based on revenue or profit (EBITDA) but the earn-out can also depend, for example, on the number of new customers. In any case, the chosen measure should be based on objective data, such as financial statements or customer data.
Define and limit duration
It must be clear in advance over what period the earn-out will be measured. This may be a fixed number of years or linked to a specific event, such as the launch of a new product. In all cases, it is important that the earn-out period is not too long, as outside influences and other unforeseen circumstances can then undesirably affect the earn-out.
Determine the payment structure
The earn-out provision should specify how and when payments will be made to the seller. Will the payments be made in a lump sum or in installments? Will interest be paid on the outstanding balance? Can good years compensate for bad years?
Take into account impact of future changes
After the acquisition, the buyer has power over the target and can therefore also change the business operations. For example, if the buyer wants to integrate the target into its existing group after the acquisition, this may affect revenue and costs within the target.
It is important to determine how these factors will be taken into account when calculating the earn-out. For example, the agreement may contain provisions designed to restrict the buyer from making changes during the earn-out period.
Address potential (conflicts of interest)
Earn-out provisions can lead to conflicts of interest between buyer and seller. For example, the seller may be motivated to make certain short-term decisions that increase the earn-out at the expense of the company's long-term prospects. Also, both parties may try to manipulate the earn-out to their advantage.
The earn-out is therefore regularly the subject of disputes. These potential conflicts can be named in the purchase agreement. In addition, the earn-out provision should provide for a mechanism to resolve any conflicts, for example by appointing an independent expert who will determine the earn-out for the parties in a binding manner if they cannot reach a mutual agreement.
Conclusion
In short, structuring earn-out provisions in purchase agreements requires careful consideration and clear wording. By clearly defining earn-out measures, specifying and limiting the duration of the earn-out, considering the impact of future changes and addressing potential conflicts, both parties can work together and achieve a win-win outcome.
