Recently, a couple of business owners received an offer to buy their company. The potential buyer proposed paying 25% of the Company’s value in cash up front and paying the remaining 75% over time, contingent on certain earn-out targets being met in the future. The owners wanted some thoughts on this structure.

Earn-outs are not uncommon in the sale of family businesses, though the features of each earn-out structure vary. Typically, a buyer defers paying the full purchase price until a particular metric is achieved, e.g., reaching a financial target, like a sales figure, or completing a business objective, like the completion of a project milestone. Usually, the earn-out target must be satisfied within some particular time period. Sometimes, there are multiple earn-out periods in which the seller has an opportunity to receive payments. Many earn-outs will accelerate on the occurrence of certain events, usually on the sale of the business or termination of a key employee.

Sellers should be cautious when an earn-out is proposed. Experienced deal professionals know that buyers can find numerous ways to avoid paying earn-outs, either by deferring revenues, restructuring the company post-closing, or prioritizing other lines of business until after the earn-out period has passed.

Last year, the Delaware Supreme Court sided with a buyer who refused to pay $40 million in earn-out payments to the former owners of the target company. The Buyer had agreed to pay $80 million for the company–$40 million in cash at closing and $40 million in earn-outs contingent on the company reaching a target revenue figure by a certain time. However, after the sale, the buyer operated the company such that the Company missed the revenue target, saving the buyer from having to pay the $40 million earn-out. The seller sued, pointing to a provision in the operative agreement between the parties that prohibited the buyer from taking any action to divert or defer revenue with the intent of reducing or liming the earn-out. The seller claimed the buyer made business decisions he knew would have the effect of failing to meet the revenue target.

The court drew a distinction between the intent of the buyer and the knowledge of the buyer. In short, based on the language in the agreement, as long as the buyer could identify reasons for his business decisions that were not motivated by an effort to avoid the earn-out, the buyer would not run afoul of the prohibition against diverting or deferring revenue, even if he knew that missing the earn-out target was the probable consequence of his actions!

To be clear, earn-outs are not always bad. They often serve as effective tools to align incentives among the seller and the buyer to ensure a smooth transition. Or they may be used to reconcile differences in the valuation of a company between an enthusiastic seller and a skeptical buyer. But as one Delaware judge has observed, “Earn-outs all too often transform current disagreements over price into future litigation over outcome.”

Earn-outs shift risk onto the seller. Anyone who is selling a family business to a buyer that insists on an earn-out provision is encouraged to strategize with an attorney experienced with the technical and legal nuances of drafting and negotiating earn-out provisions.