Mergers and acquisitions (or “M&A”) are consummated through written agreements. The terms of these agreements are often heavily negotiated and almost invariably specifically tailored to the unique circumstances of the deal being done.
Related: Buying A Business In Washington
One term, which you won’t see in every agreement but does show up in plenty of deals, is an earn-out. This term is highly adaptable and can help get a deal done even when the parties don’t agree on the value of the target company, but it will almost always increase the complexibility of the deal and is thus a topic of interest for lawyers in general and this lawyer in particular.
The Basics
So, what is an earn-out? In its most basic form, an earn-out is a term that makes some or all of the price paid for the target company contingent on the target company hitting certain performance benchmarks after the deal closes. In other words, the seller has to “earn” some of the purchase price by the target company performing well after the deal.
Note: The “target company” in a merger or acquisition is the company that’s being purchased.
Consider an example. Company A acquires Company B for a purchase price of $5 million. However, the deal is structured so that Company A only pays the seller half of the purchase price ($2.5 million) at closing. The remaining $2.5 million will only be owed by Company A to the seller if within one year of the closing Company B has added 10,000 new end users. If Company B only gets 9,000 new users in the year after closing, then Company A will not owe the seller the remaining $2.5 million.
When Earn-Outs Are Used
You’ll most often see earn-outs included in deals when the parties disagree on the value of the target company but still want to do the deal. This might seem like a raw deal for the target company, and it certainly can be, but it also can increase the upside for the target company.
A target company with a proven track record may not be as concerned with maximizing the upside and so a dispute over its value may simply lead to a deal not happening. Newer companies, on the other hand, may see an earn-out as a way to sell high on its growth potential and bet on future success to maximize the payout under the deal. The same may be true for companies that are struggling and who are motivated to sell for that reason, as it provides some money on the front end and a shot at salvaging additional value from the company if the buyer turns things around.
Tip: Earn-outs may also be used when the buyer wants to acquire the seller because the two businesses are expected to complement each other well, in which case the target company’s performance may shoot up once it has access to the buyer’s resources, technology, personnel, etc.
These are just a few of the most common reasons you’ll see earn-outs used, but there are plenty of other circumstances that may lead to the use of an earn-out provision. Just know that no matter the reasons for their use, they’ll almost always shift the assumption of risk in the deal away from the buyer and onto the seller.
How Earn-Outs Are Structured
Earn-outs can be structured in just about any way you can imagine, and so it is more helpful to identify some of the frequent issues that arise in this process than to try to enumerate the different structures you could encounter. A handful of the most common issues are summarized below.
- Setting the benchmarks or targets is probably the most common and heavily negotiated issue in structuring the deal. Revenue targets are common but any number of metrics can be used. Whatever the metric, it should at the very least be clear, easy to measure, and in line with what the target company’s business is.
- Detemining the length of the earn-out period is another issue that’s hard to avoid. Setting targets is one thing but linking them to set time periods is another; these two issues will inevitably go hand-in-hand.
- Agreeing on how performance will be measured is yet another sticky issue that may be extensively negotiated. In concert with this the parties will likely build in a mechanism for resolving future disputes relating to this issue.
- Establishing the obligations of the buyer and rights of the seller after the deal closes. The point of this is usually to protect the seller from having the buyer take steps to deliberately sabotage the earn-out once the deal is done. Of course the buyer may be resistant to restrictions on how it can run the target company once it’s been acquired.
- Getting a commitment from the sellers to continue being involved in the businss of the target company for a certain period of time after the deal closes. This doesn’t happen in every deal, but some buyers will want the sellers to stay on and run the target company or at least be involved in its management.
Again, this list isn’t exhaustive. Structure determines success with earn-outs and so there are plenty of other issues that can and do arise depending on the circumstances of a given deal.
Takeaways
The main takeaway here is that while it’s useful for the client to understand the basics of an earn-out, the business lawyer is going to be doing some of the heavy lifting here, especially concerning potential risks, contingencies, ambiguities, and other things that could jeopardize the efficacy of the earn-out mechanism.
