The purchase price is an essential part of negotiations. And especially in the current, turbulent years, (perceived) risks and opportunities are a tricky issue in this regard. The buyer only sees bears on the road, while for the seller the trees grow to the sky. To overcome such differences, parties regularly agree on an earn-out.
What is an earn-out?
An earn-out settles two elements to the purchase price of the company. First, it is a deferral of payment of the purchase price: part of the purchase price is paid in the years after the company is transferred. And then, the amount of those payments is variable and depends on future events, often on the profits earned (EBITDA).
Why an earn-out?
The seller and buyer estimate future opportunities and risks differently and, as a result, they cannot lock in the purchase price between them. To bridge those differences, they adjust the standard risk allocation. The seller continues to bear some of the entrepreneurial risk - and the buyer does not bear a proportionate share of that risk. For the record, of course, that can also be a positive risk. If things go well and profits grow, the seller gets a higher purchase price.
Legal position in case of an earn-out
According to case law, the buyer must continue the acquired activities as optimally as possible, so that in the relevant financial year as much profit as possible is achieved - thus maximizing the profit-dependent purchase price. But this obligation of effort on the part of the buyer is at odds with the entrepreneurial freedom that every buyer has. After all, that buyer will always be allowed to use its control to do what is necessary to advance the business.
But: the buyer may have a conflicting interest. He wants to minimize the earn-out and is tempted to shift costs, revenue and margins. In this way the buyer has the power to reduce the profit (and thus the earn-out).
And that is why, in a good earn-out arrangement, there are always agreements on how the buyer will continue the business. Only in this way can the seller still exercise some control and manage entrepreneurial risk. This way you avoid discussion about some (entrepreneurial) decisions taken by the buyer.
What agreements in an earn-out ?
Parties can make the earn-out as extensive as they want. Still, in important transactions, as well as an attentive seller, you see at least the following elements recurring:
- The buyer has an obligation to continue business operations unchanged. Often this obligation is reinforced with a prohibition against making certain important decisions without the seller's prior consent.
- There are consequences if the buyer does not comply. For example, a clause stating that after a breach, the purchase price will still be fixed and payable at once.
- The seller gets full access to the books so he can check what has happened.
In particular, the fixed payment and access to books are important to improve the seller's (evidence) position in a discussion about settlement.
Conclusion
If circumstances call for it, the earn-out can be a useful solution to overcome uncertainties in the purchase price. But the earn-out can also be a source of discussion, especially if the buyer can siphon off margin and profit. The observant seller should therefore be wary and arrange his evidential position already in advance.
