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Understanding Earn-outs

Wednesday, 13 February 2013

The sale and purchase of a private business can take a number of forms and include a variety of payment structures. A simple cash payment may not always be the most suitable approach when one company buys another, particularly if the buyer and seller are some way apart in terms of valuation.

An earn-out can be used to bridge these valuation gaps - a proportion of the price is paid upon completion and the balance is paid at a later date or dates if specified performance criteria are met.

Features of Earn-outs

Each earn-out will have its own detailed characteristics but they share a number of common traits:

  • The seller retains risk in the business post-completion
  • The buyer reduces the risk of overvaluing the company
  • The price is variable and related to pre-determined performance targets
  • Performance targets are based on financial metrics such as turnover, profit or EBITDA
  • There is a fixed earn-out period of around 12-36 months
  • Limitation clauses are normally included e.g. upper limits on the final price

By retaining some of the risk post-completion the seller hopes to increase the final price that a buyer will pay over a straight cash payment.

Motivation for Earn-outs

Earn-outs are useful when there is disparity or uncertainty about the value of a business. This is common where the business is relatively new, it is pre-revenue or it is growing quickly.

Sellers may be willing to retain some risk in the business if they are confident about its prospects and would like to realise its full value. This risk should be rewarded with greater return through higher valuation.

Earn-outs may also be used where owner managed businesses are sold but the management remain in place. This provides an on-going incentive to the management to meet performance targets.

Negotiating Earn-outs

Evidently earn-outs will reflect the tension between the value a buyer places on a business and the value a seller places on it. Therefore, it is important that the earn-out provisions in the sale and purchase agreement genuinely reflect the intentions of the parties and manage them appropriately.

Common concerns include the seller’s lack of control over a company post-sale and the potential for the buyer to manipulate the relevant performance criteria in order to lower the final purchase price. From the buyer’s perspective, it will not wish to have its hands tied from running the business as it sees fit.

If the seller’s management is to remain in place, there must be appropriate clauses to deal with early leavers whether it is on good or bad terms.

If you need advice when buying or selling a business, Rollingsons has experienced lawyers who can assist you. For more information please contact James Crichton via e-mail or by telephone on 0207 611 4848.