On the surface it seems simple. The definition of “fair market value” is the price at which a willing buyer will buy and a willing seller will sell, in an open market, where the parties are at arms-length and not related to each other. But what if a portion of the value is based, not on past performance, but on future earnings? Valuing the likelihood of future earnings growth is always challenging but especially so in the context of business acquisitions. Sellers may overestimate future earnings, while buyers may be unwilling to pay for earnings that may prove ephemeral. In many instances, the solution is an “earn-out” – the transactional equivalent of putting your money where your mouth is. Earn-outs provide for additional, post-closing payments to sellers based on fulfillment of conditions or financial objectives specified in an agreement. Earn-outs are a common technique in business transactions, and understanding their risks and rewards can help to avoid post-closing problems.
What is an Earn-Out?
An earn-out is a post-closing payment made to the seller based on attainment of identified financial or operational objectives. Although it is paid after the closing of a sale, it is not simply a post-closing adjustment. Post-closing adjustments are payments made to adjust for changes in the business that may have occurred prior to closing but which are not necessarily reflected on the closing date financial statements. Such adjustments typically take place within months after closing and are calculated based on financial records that are usually prepared in a manner consistent with pre-acquisition practice. They are not dependent on the fulfillment of any contingency.
In contrast, an earn-out is a portion of the purchase price that is contingent on the fulfillment of certain objectives. An earn-out provides a mechanism that can mediate the differences between buyers and sellers in valuing the business.
The most common form of earn-out relies on the acquired company meeting certain financial objectives within a specified time period. The financial objectives may be based on revenue, profitability or a formula contained in the acquisition agreement.
Not all earn-outs rely on financial benchmarks. Operational milestones such a securing regulatory approvals or intellectual property protection, favorable resolution of litigation or increasing the number of new customers may also be triggering events for an earn-out payment.
Earn-outs also vary with respect to the amount of post-closing involvement required of the seller. Some earn-outs are structured with the expectation that the seller will be actively involved in post-closing operations and will be instrumental in realizing the financial or operational objectives embodied in the earn-out. In such situations, an earn-out incentivizes the seller to realize the potential growth of the business. In other transactions, buyers may be unwilling to cede or delay operational control to a seller. In such situations, fulfillment of the earn-out contingencies may be within the control of the buyer who assumes operational control.
Why Bother?
While earn-outs present both opportunities and challenges for both parties, in many respects earn-outs favor buyers over sellers. A buyer who negotiates an appropriate earn-out may benefit from the “free” use of the seller’s capital until the earn-out payment is made. It also mitigates the risk that the buyer may have overpaid for the business. Where the earn-out is based on achieving a financial objective, the buyer is making payments if and when there is sufficient revenue from the business. In situations where a seller’s support is critical to the continued success of the business, an earn-out can incentivize the seller to use best efforts to achieve the earn-out benchmarks.
Although the benefits of an earn-out to the buyer are significant, it is not without risks. In those instances in which the seller has some responsibility for achieving the benchmarks, post-closing covenants may restrict the buyer’s ability to make operational changes during the earn-out period. These restrictions may delay operational integration or changes in financial accounting practices. Even in those instances where the seller’s connection to the business is severed, the provisions of the acquisition agreement may provide the seller with the authority to audit the buyer’s financial records to ensure that the financial benchmarks are not being manipulated to defeat the earn-out.
If the benefits of an earn-out to a buyer are potentially significant, a properly drafted earn-out, coupled with express provisions addressing the obligations of the parties during the earn-out period, may provide a seller with financial rewards that would not be otherwise available. An earn-out provides a seller with a potentially higher purchase price than a buyer would have ordinarily paid or could have easily financed. It may also provide the seller with an opportunity to exit the business at a time when economic conditions are favorable, while preserving the opportunity for upside rewards later. Earn-outs may also offer the opportunity for a seller to defer income and possibility benefit from favorable tax treatment that would not be available if the payout were made on the closing date or as part of an employee compensation package.
Depending on the nature of the earn-out, however, it may be necessary for the seller to remain involved in operations. Such involvement should be assessed in terms of both the personal preferences of the seller and the potential for continuing liability to third parties and to the seller, under the terms of the purchase agreement. Continued operational control by a seller may have the effect of continuing liability for torts, create or extend affirmative convents on seller behavior and delay the commencement of a non-competition restriction.
In those instances in which the seller is making a clean break from business operations, the seller must rely on the provisions of the purchase agreement to secure fair calculation of the earn-out. In order to minimize manipulation of the earn-out formula, the purchase agreement may restrict or otherwise limit operations during the earn-out period, and contain a requirement of separate financial records for the business as it was structured pre-acquisition.
What to look out for?
Whether either party realizes any benefit from an earn-out depends in large measure on the provisions contained in the transactional documents.
Defining the triggering events for payment of an earn-out is crucial. In the case of a non-financial benchmark – for example, an increase in volume or new customers; regulatory approvals; acquisition of a property or similar events – the triggering event may appear to be straightforward. Nonetheless, careful drafting is required to anticipate situations that may differ from those contemplated by the parties. For example, when an earn-out is triggered by a grant of “regulatory approval,” the parties need to consider the impact of a conditional approval, or an interim approval that is subject to adjustment or appeal.
Precise and artful drafting is even more important when the earn-out trigger is a financial benchmark. In addition to the traditional drafting considerations of defining an accounting methodology to measure performance, such as deviations from GAAP, use of representative base years and other metrics, the possibility that some or all of the operations of the target company may be commingled with operations of an acquiring company can introduce complexity into any earn out calculation. Sellers should be wary of how operations of the acquired company may impact the calculation of the earn-out. Consequently, parties frequently calculate earn-outs based on earnings before interest, taxes, depreciation and amortization (EBIDTA) as the appropriate metric to capture operational income. EBITDA, however, does not solve the problem of additional costs that a buyer might incur that might depress earnings, such as increasing overhead costs, changing suppliers or increasing marketing. To avoid a calculation that might depress earnings and favor a buyer, sellers frequently prefer to calculate earn-outs based on sales rather than earnings.
The selection of the correct financial formula is also affected by the structure of post-acquisition operational control and whether the seller will remain actively involved in the business. In instances where the seller is relinquishing control, the parties sometimes agree on a structure that would require adjustments that would back out post-acquisition changes so that any financial benchmark would be calculated as it has been historically.
The timing of earn-out payments must also be carefully considered. While it is common to include a date certain for earnings, sellers should consider situations in which an extension of the earn-out period might be warranted. For example, a machine failure or short-term operational issue, could easily cause an earnings miss. While a longer earn-out period provides some flexibility for such calamites, it may also inhibit a fuller integration of the business or financial operations, particularly if the earn-out is calculated based on historical methodology. In other instances, the parties rely on general force majeure provisions for satisfaction. Such provisions – particularly with respect to what constitutes a force majeure – must be carefully considered in the context of earn-outs.
Given the potential for misunderstanding and disagreement, it is exceedingly important to include a dispute resolution technique related to the earn-out. It is not uncommon to expand the dispute resolution provisions that deal with working capital or other post-closing adjustments to include earn-out disputes. Typically, such disputes are resolved by an independent accountant or a panel of accountants. In extending such dispute resolution techniques to earn-outs, it is important to revisit such provisions to ensure that the standard to be used by the third-party accountant comports with the methodology of the earn-out.
How do the courts treat earn-outs?
Careful drafting is critical in any acquisition agreement but is especially important in the case of earn-outs. The risk of poor draftsmanship of earn-out provisions generally falls on the seller. Moreover, courts have not generally “saved” sellers from the effects of imprecise or vague drafting. For example, although a covenant of good faith and fair dealings is a part of every contract, the Delaware Court of Chancery, which is highly regarded for its handling of disputes involving complex commercial transactions, has found that a buyer did not act in bad faith in failing to negotiate lower distribution fees that would have had the effect of an increased earn-out payment. In another case, the Court held that the implied covenant of good faith and fair dealing was not violated when a buyer refused to adopt technological improvements that would have resulted in payment of an earn-out. In cases where the Court was willing to consider a violation of the implied covenant of good faith and fair dealing, the evidence adduced by the seller was quite high.
In drafting earn-outs, sellers are well advised to include specific language to require buyers to maximize earn-out benchmarks, while buyers will wish to avoid covenants which impinge on their judgment in operating the business. Negotiating this balance is an important part of any purchase transaction.
While the notion of “paying as your go” for an acquisition has appeal for both buyers and sellers, earn-outs can be fraught with risks. For sellers they offer an opportunity to realize the “true worth” of the company. For buyers, they potentially offer cost free financing and a buffer against overpayment. What is apparent from a consideration of the provisions and the case law is that to realize any benefit, an earn-out provision must be constructed with precision and with a thoughtful consideration of the context of the business. Anticipating and discussing changing circumstances and negotiating explicit provisions is critical to avoiding disputes and realizing the results contemplated by the parties.