Earn-outs explained: balancing risk and reward in M&A transactions

An earn-out is a price adjustment mechanism in M&A transactions found in Sale and Purchase Agreements. This flexible structure can be tailored to fit the specific features of a deal. Typically, it involves the buyer paying a portion of the purchase price at the time of completion, with additional payments made to the seller based on the target company's financial performance post-completion.

They are frequently used in deals involving technological, pharmaceutical, and medical companies. They are also used in deals involving ‘people businesses’ (e.g. PR or marketing agencies) where the value can be harder to pin down and/or there may be a concern that the goodwill is tied to the identity of one or more of the sellers. Start-up acquisitions also often include earn-outs due to the difficulty in valuing such companies. Buyers use earn-outs to protect themselves against overpaying for a company that may not grow as expected.

An earn-out reduces uncertainty and risk related to several factors, including:

• valuation of the target company
• economic and political developments
• target entering new markets with innovative products
• limited historical information about the target
• market volatility
• recent declines in the target's earnings
• recent changes in the target, such as restructuring or changes to the board

The final price is determined by the actual future performance of the target rather than anticipated performance, significantly reducing the buyer's investment risk. Additionally, if the buyer lacks sufficient funds to pay in full at completion, the earn-out period defers part of the payment, reducing the need for third-party financing. It also incentivises sellers to remain involved and perform well.

For sellers, earn-outs allow negotiations to proceed without agreeing on the final value of the target company. If the target has substantial growth potential, an earn-out provides the seller with the opportunity to achieve a higher price based on actual performance during the earn-out period. The seller can benefit from the combined expertise and synergies resulting from the buyer and seller working together during this time.

Earn-outs can be challenging to structure and costly to negotiate. Constant monitoring and fluctuations in profitability or turnover can lead to disputes. Measuring the earn-out during the integration of the buyer's and seller's businesses can be complex, and the arrangement does not allow for a 'clean break' at completion. The operation of the earn-out can be subject to manipulation, especially if based on profits, requiring careful drafting and good faith from both parties.

When negotiating an earn-out structure, it is crucial to select the relevant benchmark for calculation, which could be based on:

• the target's future profits
• future turnover
• number of new customers acquired
• number of products sold

The Sale and Purchase Agreement should also address the following points:

• duration of the earn-out period
• frequency and method payments
• tax implications
• dispute resolution mechanisms
• extent of integration between buyer and seller
• restrictions on the target's trade or investment during the earn-out period

If you are thinking of selling your business and an earn out is likely to be part of the deal, do speak to us first as the heads of terms are vital in getting appropriate protections in place.

Sunil Landa is an associate in the corporate and commercial team.