Earn-outs – where part of the purchase price is conditional upon the future financial performance of the target -  are enjoying something of a revival in M&A deal structuring. A combination of seller price expectations and continued tightening in the debt markets makes this a useful tool to bridge the gap between the principals’ respective valuations.

This article looks briefly at the typical earn-out structures and the threats and challenges for the unwary – on both sides of the deal. We refer to Sellers and management teams interchangeably.

When is an earn-out appropriate?

• Earn-outs are commonly used as a device to bridge the divide between the parties’ valuation perspectives e.g. where the target has an immature trading record, is a pre-revenue business or has significant potential for growth.  Where the Buyer is seeking to use the structure purely to assist its funding then Sellers should beware – unconditional seller notes supported by security become a more appropriate structure.
• The structure can also be used as an incentive for the management team e.g. on the sale of an owner managed business where the team are staying and are critical to the business.
• From a buyer’s perspective the structure has a number of aspects to commend it – the buyer mitigates any risk that it may be over-paying for the target, eases cash-flow and limits its exposure to trading or economic vagaries in the earn-out period.
• From the Sellers’ perspective cash up-front is always preferable but an earn-out does present an  opportunity for them to achieve full value for their business. Provided the earn-out payment reflects the risk to the Sellers inherent in these arrangements it can be regarded as a reasonable compromise (the earn-out amount should exceed the likely nominal value of a seller note).

Structuring the earn-out

The key issues for the parties are the financial metrics to be used, the earn-out period and limitations on the earn-out payment.

• Financial metrics. The earn-out target can be based on any metric provided it is measurable. The most common are tied to the business’s Turnover, Gross Profit or EBITDA though depending on the nature of the business other targets may be more appropriate (e.g. product approval in a life sciences business). The key for the seller is to insist on the target being set as close as possible to the top line - to minimise the buyer’s capacity for manipulation of the key number - while the Buyer’s objectives are opposite as the table demonstrates:

• Earn-out Period . Anything between 12 and 36 months is common. Anything less will be too short to give the target business time to sensibly prove itself and anything longer a recipe for dispute, distraction and a disincentivized management team.
   
• Limitations. The Buyer may not unreasonably (and almost inevitably if it is being funded) insist on an upper limit on the earn-out payment. While having regard to the risk compensation mentioned above this is something which a seller should be comfortable accepting.

Negotiation issues

• Seller protections: The Sellers will be concerned to ensure (1) that the target business is operated on substantially the same basis as pre-completion (the greater the operational autonomy enjoyed by the sellers/ management team, the less the need for lengthy restrictions on the Buyer) (2) the Buyer is restricted from taking any action which will undermine the business’s ability to achieve the financial target (e.g. via levying management fees) and (3)  the sellers are permitted the necessary resource (personnel and financial) to support the business in the earn-out period.
  
  These aspirations to “ring-fence” the business will need to be weighed against the Buyer’s desire to run the business as it sees fit (“surely we have a mutual interest here?” says the Buyer in feigned innocence) and integrate the target to achieve the synergies which will typically underpin its economic rationale for the deal. Similarly the words “eat” and “cake” will spring quickly to mind as the Buyer mulls the Sellers’ arguments that intra group charges be excluded while simultaneously cheerily accepting the savings which will follow as part of a larger group with commensurately increased buying power.
  
  Bottom line - these are real and substantive concerns for the sellers who should insist on specific and precise protections rather than vague unquantifiable promises. Provided that the Sellers requests are sensible and consistent with good governance the Buyer should accept them.
   
• Management departures: Where the sellers comprise a management team the earn-out will typically act as an incentive plan (and the proceeds will frequently be skewed against non-executive sellers).  What to do if a member of the team leaves early? The Buyer will be cognisant not just of the circumstances surrounding the departure (and whether these render the individual a “good” or “bad leaver”) but the impact on the remaining members of the management team who may be concerned that their ability to hit target has been holed below the waterline and/ or that the entitlement of the departing member should pass to them.
  
  Bottom line – the Buyer should heed management’s reasonable requests. Getting and keeping them on-side is usually integral to the success of the deal.Disposal of the target business:  What happens if the target is sold during the earn-out period? Similarly if control of the Buyer changes hands then issues will inevitably arise for management who struck a deal with a different party. It will be neither possible nor desirable to cover every eventuality in the legal drafting – the parties will need to rely on trust and common sense in many areas. This is one such area; if the business does so well that the Buyer can exit it within the earn-out period then the sellers/ management will have earned their earn-out (and some!) and buying-out the earn-out will be a small price to pay in the scheme of things. 
   
• Management departures: Where the sellers comprise a management team the earn-out will typically act as an incentive plan (and the proceeds will frequently be skewed against non-executive sellers).  What to do if a member of the team leaves early? The Buyer will be cognisant not just of the circumstances surrounding the departure (and whether these render the individual a “good” or “bad leaver”) but the impact on the remaining members of the management team who may be concerned that their ability to hit target has been holed below the waterline and/ or that the entitlement of the departing member should pass to them.
  
  Bottom line –  drifting firmly into the Buyer’s territory – an accelerated buy-out of the entitlement can be a fair compromise

• Calculation of the metric: Having settled on the target (Revenue/ Gross Profit/ EBITDA/ cash flow etc)  it falls to settle the accounting rules and principle to apply in calculating it. The choices will vary between the seller’s pre-closing policies, to UK GAAP, the Buyer’s accounting policies and points in between. Extraordinary items – whatever the impact – should be excluded (the earn-out should be based on the ordinary course of business activities of the target). Ensure the drafting captures the commercial and accounting issues and concepts.
  
  Bottom line - in the absence of a flaw in the Seller’s accounting policies it is not unreasonable to adopt them. A comprehensive set of guidelines for the accountants is desirable – certainty now reduces the scope for dispute later
   
• Disputes: In the unhappy (albeit not uncommon) event that issues arise on determination of the target metric then the documentation should contain a clear procedure for swift resolution.  Typically the Buyer’s auditors (who will also be the target’s auditors) will prepare initial drafts for review by the sellers/ their advisers. Sensible time frames should be set and the parties and their advisers should be obliged to co-operate with the production of working papers etc to achieve an agreement. If matters cannot be resolved then independent experts should be engaged – acting as experts and not arbitrators.
  
  Bottom line – not unreasonable to allow the Buyer control of production of the information with sensible safeguards for the Sellers to challenge and monitor compliance.

Summary

• Earn-outs have potential to bridge and create divides. The parties should recognise the inherent conflict in their approaches (Seller – short term profitability to hit target/ “ring-fence” their business: Buyer long term sustainable profitability/ integration and synergies) and accept that while there are some fundamental areas where each side can reasonably expect protection, trust and common sense need to prevail.
• The more precise and detailed the wording the better – for both sides.

(This is one in a series of  articles by the PSW corporate team on trends and issues in M&A deal structuring)