Lack of cash and/or borrowings and a widespread lack of confidence in these challenging times are resulting in more M&A deals being done on the basis of an element of deferred, and often contingent, purchase price. Earn-outs are now an even more common feature in deals.

What is an earn-out?

An earn-out is a seemingly simple idea: at least part of (and sometimes all of) the purchase price is to be calculated by reference to the future performance of the acquired business and paid later. This structure can have advantages for buyer and seller. The seller gets a chance to "earn" a premium purchase price for the business. The buyer can bridge the gap in the seller's price expectation and remove an element of risk from the deal. Clearly, there are also cash-flow advantages for the buyer.

Although they make sense for many different reasons, earn-out deals can be difficult to negotiate when it comes to documenting the deal. We find that it is helpful for buyers and sellers to think about the issues when negotiating the deal structure and phasing of price payments because early analysis allows the deal to move more smoothly through the "legals".

What are the top 10 issues to think about with earn-outs?

  • the amount of the price which is to be deferred and linked to performance, for how long and whether that deferred element should be subject to a cap
  • the risk of payment default by buyer
  • what security should the seller get from the buyer for payment of the deferred purchase price
  • whether the seller or the buyer has control of the business during the period of the earn-out and the extent to which that control should be subject to checks and balances
  • the potential for manipulation of the performance of the acquired business by the buyer or the seller (depending on who has control) during the earn-out period
  • agreement as to treatment of events which are not "ordinary course" and which should be ignored or added-back for the purposes of calculating the earn-out formula
  • disagreement after the deal is done as to the amount of the earn-out
  • what happens to the earn-out if the seller ceases to be employed in the acquired business during the earn-out period
  • whether payment of the earn-out should be accelerated if certain key events occur, for example, a sale of the company or its business by the buyer
  • tax - earn-outs can raise complicated issues.

For more detailed information on points for consideration in relation to each of these 10 issues please click here.