In this article we cover:
Why do earn-out disputes arise?
Sellers and buyers of businesses often have a very hard time reaching agreement on the value of a company. A company valuation may be made on the basis of projected cash flow, and this can be highly speculative. A buyer may be prepared to accept a seller’s valuation at face value, but make their offer to purchase conditional on the seller receiving part of the purchase price on an earn-out basis.
There are several reasons why earn-out disputes may arise:
- The seller may have presented an over-optimistic view of the target company’s prospects, as reflected in over-ambitious performance measures that are then disputed
- The earn-out clauses in the sale and purchase agreement may not have been clearly drafted without ambiguity
- There may be disagreement as to how the performance measures should be calculated
- The seller, during the post-sale period, manages the target business in a way that maximises the company’s short-term performance in order to meet the earn-out performance measures, to the detriment of the company’s longer-term financial health
- It may be more difficult than anticipated to incorporate the target company into the purchaser’s group, causing a dip in performance unrelated to the underlying merits of the business
- Whether the performance has met the targets may be too close to call with sufficient accuracy
- There may be a dispute relating to the method of preparation of the accounts
- The parties may not have thought about what will happen if, say, the buyer decides to sell the business
Avoiding earn-out acquisition disputes in sale purchase agreements
Unfortunately, earn out payment disputes are quite common. There are however some general rules both parties should follow when drafting the sale purchase agreement.
- Set realistic goals when drafting targets. Be aware, if you are a seller, that it’s unwise to set over-optimistic goals to justify a higher valuation, as you’ll be storing up problems down the line
- Try to avoid over-complex calculations and measurements by which the earn-out will be calculated, as these can be fruitful areas for dispute
- If, as a seller, you will be remaining in the company post-completion, try to keep control of the company by retaining key members of staff, avoiding an over-long earn-out period, and consider vetoes over certain decisions by the buyer that could impact your pay-out
- Ensure that you clarify what will happen if external events adversely affect the company’s performance post-completion
Earn-out structure
Here are some key points to consider when considering how an earn-out will be structured:
The earn-out clause should at a minimum include the following elements:
- A clearly defined earn-out period, with benchmarks and timings for earn-out payments
- Relevant performance indicators
- How performance will be measured, and the method for determining any disputes
- What the seller’s continued role will be in the management of the company during the earn-out period
- How the purchaser will manage the company following the purchase so that disputes can be avoided if management impacts negatively on the performance of the company
- A dispute resolution mechanism
What targets will be used to trigger earn-out payments and are they financial or non-financial (customer churn, regulatory approval for example). How long will the earn-out period be, and when will the payments be made? Is there a single payment at the end of the earn-out period, or stage payments? Will interest be payable on late payments?
For more information, see our article How to structure and negotiate an earn-out.
Calculation of the earn-out amount
There are multiple possibilities for calculation of the earn-out amount. This can be a set sum, payable on achievement of the relevant target, or a series of amounts that vary from period to period. The earn-out amount may be a percentage of any profits achieved, or a multiple of that amount, and these sums could be capped or subject to a minimum. Will the earn-out sum be payable in cash or other consideration such as shares?
Variation in performance
Think carefully about how to tackle variations in performance year-on-year when considering earn-out targets. Can performance be ‘smoothed’ over periods to avoid the situation where the company over-shoots performance in one financial period but under-achieves the next? Can the buyer claw back payments made on one year, if the company fails to perform in the next period?
Defaults
Will an earn-out payment be accelerated in the event of a default by the seller of a covenant in the sale purchase agreement, or in another event such as a sale of the company or its insolvency.
Calculation of performance
Will management accounts be used to determine whether the company has performed as expected, or will the statutory accounts be used? Who will do the necessary calculation, the buyer and their advisors or the seller? Will there be a time limit within which the calculations must be received and approved by the buyer? What accounting rules and principles will be used, and are there any particular policies that should be agreed up-front?
If the buyer’s accountants prepare the accounts, will the seller be able to question or challenge them? What happens if they disagree with them, and are there any time limits for raising objections? Will the seller have access to the documents and records used to make the calculations?
Dispute resolution procedure
If the seller and buyer can’t agree how to resolve a dispute, what happens next? Will an expert be appointed, and how should that person be chosen? What will be their scope, and what procedure will be followed? Will both sides be entitled to ask questions and challenge any determination? Who will bear the expert’s costs?
Merged operations
It can be very difficult to measure the true performance of a company post-acquisition, particularly when its operations are merged into the buyer’s company. For that reason, it’s a good idea for a seller to insist that separate books and records are kept where the target company’s performance can be accurately measured. It may also be possible to agree that the performance should be calculated on a consolidated basis with the buyers group, allocating a specific percentage to the target company’s operations.
Delaying the start of the earn-out period
It may be possible to delay the start of the earn-out period to allow the company to ‘bed-in’ to new management and absorb exceptional costs relating to the acquisition.
Practicalities
Make sure that you have considered whether there will be sufficient time and attention to give to the preparation of the calculations that relate to the earn-out amount, as well as the availability of staff including accountants and professional advisors.
Length of the earn-out period
As a buyer, you will want to avoid an over-long earn-out period, as an over-long period may not give a true picture of the underlying merit (and value) of the target company. It should also not be too short, so that any costs relating to acquisition have time to be absorbed into the business.
Other provisions
Additional provisions can be helpful in minimising the likelihood or potential for disruption and cost of earn-out disputes:
- Arbitration or conciliation. The sale and purchase agreement might require that disputes be resolved only by arbitration, and that this be the sole method of resolution. They can also define the procedure that will be followed by the arbitration in order to limit the range and scope of matters that can be considered.
- Avoiding ‘all or nothing’ payments that are contingent on targets being met, and providing instead that a percentage of a staged payment is made if the targets are partially achieved
- Requiring one party to bear another’s costs if they make an unsuccessful challenge in an earn-out dispute
Earn out protections
The period following sale is crucial in terms of calculation of the earn-out amount. Both the buyer and the seller will be keen to build in protection in case of manipulation of the management of the company in order to affect the earn-out payments.
Earn-out period issues
The seller will be concerned to see that the buyer manages the company post-completion in such a way that the risk of not meeting the relevant targets is minimised. For example, a seller may insist that the buyer doesn’t make material changes to the way the business is run, or ask that certain decisions are prohibited during the earn-out period, such as a veto on firing key staff or taking on too much debt. They might also insist that the buyer dedicates a sufficient budget to marketing and sales activity post completion.
Seller’s involvement post-sale
If the seller will continue in the business post sale, the buyer will want to ensure that they manage the business efficiently during the earn-out period so as not to adversely affect performance of relevant targets. Consider what will happen if the seller decides to leave the business before the end of the period.
Earn-out on asset purchases
It’s possible to include an earn-out when the purchase of a business is structured as an asset purchase rather than a share sale. The same considerations apply to the way the earn-out is structured, and the sale purchase agreement drafted.
Earn-outs on the term sheet
When negotiating a term sheet that envisages an earn-out, you should consider the same issues that we have looked at in the context of the sale purchase agreement. Being clear up-front about the parties’ expectations and paying close attention to drafting at this point can avoid the potential for misunderstanding later on. In summary:
- Agree what performance indicators will be used to calculate the earn-out amount
- Decide when the earn-out will be paid, and how it will be structured
- Agree how the company’s performance will be measured and how disputes will be resolved
- Determine what the seller’s rights and duties will be post-sale in connection with the management of the company, and whether there will be any restrictions on the activities of the company during the earn-out period
Earn-out alternatives
The buyer is usually in the driving-seat when it comes to earn-outs. The usual reason for agreeing an earn-out is to bridge the gap between the seller and the buyer’s valuations. An earn-out can also limit risk to the buyer post-sale, where the seller is required to remain in the business for a period after the sale to ensure that the value to the buyer is maximised.
There are several problems with earn-outs. Firstly, there’s a mismatch of interests where the seller remains in the business post-sale. The buyer in theory controls the company, but the seller needs some of that control given to them during the earn-out period to ensure that the performance targets can be achieved.
Secondly, during the earn-out period, there’s the potential for the earnings of the business to be manipulated post-sale in order to affect the earn-out amount. The seller might drive down costs artificially to boost earnings, or the buyer could inflate costs to decrease profits.
One alternative to an earn-out is a staggered purchase, where a valuation for the business is agreed. The seller gets cash on completion and either shares in the existing business or the Newco set up to continue the business post sale. The seller’s remaining shareholding are then sold to the purchaser on a staged basis during a set period similar to the earn-out period on the basis of put options valued in accordance with an agreed formula and exercisable on a staged basis. Alternatively call options can be agreed in favour of the buyer. The seller remains on the board of the company, and can opt to exercise the options or remain working for the company. Equally the buyer may choose not to exercise the call options and operate the business jointly with the seller.
This kind of staggered arrangement requires that the seller and the buyer work closely together to manage the business post-sale, and is less susceptible to manipulation by either side.
Earn-out seller protections
As we’ve seen, when an earn-out is based on future earnings, the interests of the buyer and seller are mis-aligned, post-sale. Should a buyer, for example, lose key customers, sell key assets, or otherwise take decisions that have an impact on earnings, the value of the earn-out for the seller may be reduced.
For this reason, the seller is frequently required to remain in the business for a certain period to protect their interests post-sale. In order to protect their interests properly, you should ensure that a service contract or employment agreement be put in place setting out the terms of the agreement, which also contains provisions that prevent the buyer from restricting the seller from achieving performance goals, such as artificially reducing the marketing budget or cutting staffing levels.
Equally, if the seller is not going to stay on the business, the sale and purchase agreement should contain protections in their favour that restrict the buyer’s actions post-sale that might impact revenue or profitability. The buyer might be required to manage the business in a substantially similar way as it was operated before the sale, so that the earn-out figure has the best chance of being achieved.
Our earn-out solicitors specialise in mergers and acquisitions (M&A) for start ups and high-growth businesses. Contact us now by filling out the enquiry form below or by phoning 0808 164 8732.
