It is not always possible for a buyer to meet a seller's valuation expectations, especially when the seller is seeking upfront value for, among other things, expected rather than actual revenue or profit. In these circumstances, the buyer and seller may attempt to bridge the gap and agree the terms of an earn-out.

What is an earn-out?

Under a typical earn-out structure for a private M&A transaction, the buyer will make an initial payment of consideration at completion and one or more deferred contingent payments over a specified period following completion calculated by reference to the target's performance during that period.

Earn-outs are frequently based on the target's profits over the earn-out period, but it is also possible to link the earn-out to turnover, net assets or any other financial or non-financial measure that the parties consider appropriate to a particular transaction.

Why use an earn-out?

A buyer and seller may be unable to agree on the value of a target where it lacks a track record in its performance. Particularly where the parties see significant value in the target's growth potential, an earn-out can bridge the valuation gap by facilitating a more accurate valuation based in part on actual future performance, rather than past or predicted future performance.

In some transactions, the continued involvement of target management after completion is important to ensure the future success of the acquired business. Where this is the case, an earn-out could be used as a mechanism to retain and incentivise them to maximise the target's profitability.

Advantages of an earn-out

An earn-out offers the following advantages to the seller:

  • An earn-out may allow the seller to obtain a higher aggregate price for the target. Without an earn-out, the price that the buyer is prepared to pay may be reduced by doubt about the actual profitability or value of the target.
  • It may give the seller the chance to benefit from synergies arising from the target being part of the buyer's group (eg, reduced headcount or lower property costs), which may increase the target's profits post-completion and thus increase the earn-out payments for the seller.

An earn-out offers the following advantages to the buyer:

  • An earn-out ensures that the purchase price is directly linked to the target's actual performance. This can remove uncertainty and enable the buyer to pay a more accurate price.
  • Use of an earn-out in structuring an acquisition provides the buyer with the ability to finance such acquisition with the target's future profits.

Disadvantages of an earn-out

The seller is unable to have a 'clean-break' after completion: it will remain involved in the target business, with no certainty as to the level of consideration that it can expect to receive. Similarly, the buyer will be constrained under the transaction documents as to what it can and cannot do with the target during the earn-out period.

It is difficult to predict the operational aspects of merging two businesses, which means that earn-outs terms are often unclear or do not provide for particular circumstances. A lack of clarity in drafting the earn-out terms can lead to disputes in the future and an unfair outcome for one of the parties.

Key issues to consider

There are a number of points to consider when drafting and negotiating an earn-out provision:

  • If some sellers (eg, management and employees) will continue to manage the business after completion, they will expect to run the business without undue interference from the buyer. This may conflict with the buyer's wish to ensure that it has sufficient control of the business to prevent the sellers from acting in an opportunistic manner to distort the quantum of the earn-out.
  • In particular, where no seller will be employees of the business following completion, the sellers will be vulnerable to the buyer taking steps to reduce the earn-out after completion. The sellers will therefore wish to negotiate contractual provisions which restrict the buyer from doing anything which could have this effect. Such contractual provisions can range from a broad restriction on the buyer doing anything which could distort the amount of the earn-out to specific provisions (eg, which limit the target's ability to pay dividends during the earn-out period). However, the buyer will be reluctant to agree to anything that could minimise its freedom to run the target as it sees fit post-completion and will seek to limit such provisions.
  • The most common metrics are revenue, net income, earnings before interest, tax, depreciation and amortisation (EBITDA) and earnings per share. Sellers often prefer revenue (because it is less easily manipulated by the buyer and easier to achieve) and buyers tend to prefer net income. Parties often compromise on EBITDA as a measure of profit. In some cases, non-financial measures (eg, product development milestones or numbers of products sold) can be used, particularly where there is no historical financial information to use as a basis for financial projections.
  • As well as deciding how the earn-out will be measured, the parties will need to negotiate and decide in advance other issues, including:
    • how the earn-out payments will be satisfied (ie, cash or non-cash);
    • how disputes will be resolved;
    • whether there will be interest on late payments; and
    • whether the earn-out payments can be accelerated in any circumstances.
  • The sellers may request that the buyer provides security for its obligation to make the earn-out payments. Security could be provided in the form of, among other things, a cash escrow or a parent or bank guarantee.
  • To the extent that the target business is not standalone, the seller should ensure that it is adequately supported by the buyer during the earn-out period on acceptable terms.
  • Earn-outs typically last between one and three years. Whether the parties opt for a longer or shorter period will depend on factors such as the business plan on which the earn-out has been modelled and the period for which the seller's continued involvement in the target group is required following completion.

For further information on this topic please contact Will Pearce or William Tong at Davis Polk & Wardwell London LLP by telephone (+44 20 7418 1300) or email (will.pearce@davispolk.com or william.tong@davispolk.com). The Davis Polk & Wardwell website can be accessed at www.davispolk.com.

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