A typical earn-out provision provides that the buyer pays a certain sum of money at settlement, which is an amount that is less than the full value that the buyer is willing to pay the vendor, and the balance purchase price is only payable in future if certain criteria or contingencies are met. If the criteria/contingencies are not met then the balance purchase price is not payable. An earn-out provision is one way a buyer and seller can share the risk of the transaction subsequently failing. In our experience sellers frequently struggle to achieve the earn-out component of the purchase price because the relevant criteria/contingencies are not met.
Why are the criteria/contingencies not met?
The failure to satisfy the earn-out criteria/contingencies can occur for any number of reasons some of which are not within the control of either party. A world economic downturn; a major disaster; death of a key player; change in technology etc can all operate to deny the seller its earn-out sum. In other instances the failure to receive the earn-out sum lies with the terms of the sale contract. Some typical problems which we have encountered include the following:
- the seller agreed to unrealistic targets/benchmarks – this often occurs because the seller has “talked up” the sale price to such an extent that setting a realistic level became impossible
- there was a discrepancy between the accounting concepts/principles employed by the seller and those employed by the buyer
- the seller did not have (nor would they have been given) the necessary control over the business following settlement to ensure that the targets/benchmarks were met
- the new owners borrowed heavily to provide necessary working capital and accordingly the profit significantly decreased
- the new owners charged the business various fees and charges in accordance with their “normal inter-company practice” – this ruined the entity’s earn out capability
- there was an inability, post settlement, to realistically identify the entity’s business as an independent profit centre in the new structure.
As a guiding principle in negotiating earn-out sums a selle must be satisfied with the base sum which it receives at completion and must view the earn-out sum as an added benefit – should that benefit ever crystallise.
To the extent any seller agrees to an earn-out then we will always advise them to set both a floor (there will generally be a ceiling) on the relevant targets/benchmarks together with corresponding floors on the earn-out sums payable by the buyer. We also advise them that to the extent it is possible – and often it is not (it is virtually impossible to contractually control some of the elements listed above) – the problems described above must also be addressed contractually.
Why do buyers insist on earn out provisions?
There are a number of reasons why earn-out rights are popular with buyers and they include the following:
- the enforcement of contractual warranties involves costly and protracted litigation being initiated by the buyer, whereas the retention of part of the purchase price does not
- warranties are normally read subject to disclosed material that can diminish the effectiveness and reliability of the warranties
- warranties can be subject to enforcement restrictions – caps, sunset clauses
- warranties as to future matters are either not given or are often expressed as “to the best of the vendor’s knowledge” thus making them harder to enforce.