In the sale of a company it is not uncommon for an element of the price to be in the form of an ‘earn out’.
Earn outs – what are they and why have them?
An earn out is a mechanism linking the purchase price to be paid by the buyer to the future performance of the acquired company. There are all sorts of things that this performance can be benchmarked against (e.g. EBITDA, revenue, pre/post tax profits etc) but whichever you choose the general principle remains the same – i.e. the better the acquired company performs against that benchmark, the more is payable to the seller (and vice versa).
Normally the seller will remain involved in the business for at least the period of the earn out to provide continuity of management (bearing in mind that a lot of the value in the acquired company may be in the relationships that the seller has with customers and suppliers) and also to give them the opportunity to help to drive the acquired company’s performance under its new ownership. The hope is that giving the seller an ongoing financial interest in the company’s performance should encourage them to push the business forward.
Existing earn outs – options for renegotiating?
Given the impact of Covid-19 on the performance of businesses across all sectors, there will likely be lots of sellers looking at their existing earn out arrangements with a sense of dismay as they realise that the payment they were hoping for (or perhaps even expecting) might not materialise.
However, all is not necessarily lost. Sellers should remember that it is not in the buyer’s interest to have a disillusioned / unmotivated seller involved in managing the company so they might actually be open to amending the arrangement to mitigate this. There are a variety of options here, including:
- Changing the target against which performance is measured to a more appropriate one.
- Varying the time period over which the earn out is measured (e.g. disregarding part of 2020, extending the end date etc).
- Leaving the earn out ‘as is’ but putting in place a new arrangement alongside it (e.g. a performance related bonus, options etc).
Sellers should take a proactive approach and speak to their buyer about why their current earn out arrangements are no longer appropriate in the circumstances. There is nothing to be lost (and potentially plenty to be gained) by raising the issue!
If the parties are able to agree a new arrangement, then that should be properly documented to avoid potential disputes in the future. This would then allow both parties to concentrate on taking the business forward – which is to both of their benefit.
The above is focussed on how to try to mitigate existing earn out arrangements. In my next post, I will set out some key points that need to be considered before entering into an earn out arrangement in the future.