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Missing puzzle pieces

Earn-outs: Extra Stress or an Excellent Solution?

Date: 19/01/2024 | Corporate

When selling their businesses, clients often agree in principle to some type of earn-out. Unfortunately, this is often done without really understanding what that arrangement entails and the risks involved, leaving Sellers vulnerable. In this article, we explain what earn-outs are and share the information needed to make an informed decision.

What is an Earn-out?

In essence, an earn-out is a corporate version of “buy now pay later”.  The Buyer will pay some cash up front and only make the rest of the payments when certain financial targets or commercial milestones are met.

The Buyer will usually present the earn-out as a “win-win” option.  The Seller gets some cash now, stays with the business post completion for a few years and if the business hits the agreed targets as everyone hopes then they get paid additional sums.  Their positive spin is that it allows them to pay a higher price for the business assuming all goes as well as the Seller has told them it will.

But sometimes things don’t work out as planned. Clients always need to be aware that they may never see a penny of any earn-out payments.  If a Buyer does not want to pay out for whatever reason they have a myriad of options to reduce, delay or avoid payment – forcing the Seller out of their employment or consultancy contract, manipulating the numbers so the targets are not met, bringing warranty claims or integrating the business in such a way that targets cannot be achieved.  Even with a tightly drafted agreement it is impossible to account for every scenario and a determined Buyer will always find a way to make things difficult.

Common Earn-out Risks

Each earn out is individual and tailored to the specific deal in question but there are some risks that are common to all and worth thinking about before agreeing even in principle:

What should the earn-out targets/milestones be?

Setting these correctly is important and including and understanding the precise mechanisms to determine whether these targets/milestones have in fact been reached is key. You don’t want to find yourself thinking that the targets have been hit only to have the Buyer argue that under the terms of the agreement they have not.

What should the earn-out period be?

A shorter period might not give enough time for the business to reach its potential and maximise payments but a longer period leaves the business open to external factors outwith anyone’s control which could have a very negative impact. As we now know, pandemics do happen!

What post completion integration will you agree to?

 This can have a big impact on the financial performance of a business – it needs to be clear at completion what is planned and how it will impact on the numbers so that it can be factored into the targets set for the earn-out. For example, if the buyer is going to levy high management charges, should these be carved out of any profit calculations?

How secure are you during the earn-out period?

 If your employment or consulting terminates for any reason what happens to the earn-out?  What happens if you die or become ill? Is there a different impact on the earn-out  if you resign or are terminated for some reason? Should that be permitted and if so in what circumstances?

What earn out protections do you need?

Things change especially over a long earn-out period and many clients find working for someone else in what was previously their own business very challenging, especially if actions are being taken which they don’t agree with.  It is essential to have well drafted earn-out protections to make sure there are no deliberate or accidental actions that reduce earn-out payments.  These can be controversial as the sellers usually want as near to total control as possible and the buyers want to be free to integrate the business as they see fit.  Again, the longer the earn-out period the greater the risk of relations deteriorating or buyers wanting to make significant changes to the business.

In Conclusion

Earn-outs can be a cause of conflict and to avoid that it is essential that both Buyer and Seller have a clear and detailed understanding of exactly how their agreed earn-out will work in practice.  When that is the case, they can provide an excellent solution to bridge a price gap.  Even so Sellers need to be clear that after completion there is a risk, they may never get paid anything further, so they have to be happy that the upfront payment is large enough to make the earn-out a risk they are willing to take.

If you need advice on an earn-out and how it could work for you, please contact a member of our corporate team.

The matter in this publication is based on our current understanding of the law.  The information provides only an overview of the law in force at the date hereof and has been produced for general information purposes only. Professional advice should always be sought before taking any action in reliance of the information. Accordingly, Davidson Chalmers Stewart LLP does not take any responsibility for losses incurred by any person through acting or failing to act on the basis of anything contained in this publication.

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