An earn-out clause is a contractual provision establishing that the purchaser of a business is obliged to pay an additional purchase price to the seller if the acquired business achieves specific predefined goals.
The transaction rate included in an earn-out clause seems to have stabilized between 25% and 30%. This percentage varies depending on the market and geographical scope taken for the survey. The inclusion of earn outs is more readily accepted in specific sectors, such as biotech, life science, pharmaceuticals and environmental technology, in which several studies set the rates at approximately 75% to 80%.
Business sellers and purchasers may prefer to negotiate an earn-out clause when there is a gap regarding the purchase price of the target business. Sellers might seek a higher purchase price for the target business, based on their forecast of the business’s future cash flows, while purchasers might want to lower this price.
Besides the inevitable discussions between the seller and purchaser on pricing the target business, this gap may arise owing to discrepancies when assessing the target business. The purchaser does not always share the seller’s valuation method for determining the price. The target business might not have a proven track record enabling the purchaser to substantiate the seller’s forecast. Or the purchaser might not have the required level of funding, committing only to paying a lower purchase price plus an additional earn out based on the target company achieving certain predefined goals.
The higher the earn out, the lower the risks assumed by the purchaser and the higher the risk that the seller will not reach the desired price.
Despite being useful for the parties, the inclusion of an earn-out clause may be a source of conflict and must be carefully negotiated and drafted. This particularly affects sellers, because if discrepancies arise between the parties regarding the interpretation and implementation of the earn-out clause, they will probably have to litigate against the purchaser with the earn out price in the hands of the purchaser.
What advantages does an earn-out clause imply for the seller? First, it bridges the valuation gap that may exist for the purchaser. This is particularly advantageous in deals involving targets with new technology and/or a short track record, or involving targets in a turnaround situation. It can also benefit companies seeking investors in an environment of financial constraints. Second, sellers conducting business during the earn-out period more successfully than expected may obtain a higher price than they would have accepted upfront at closing. The total purchase price including 100% of the earn out might be higher than the price the seller would have obtained at closing without an earn-out clause. Third, it may soften the tax impact of the transaction by deferring the taxation for several years.
And what disadvantages does an earn-out clause imply for the seller? First, the seller’s situation would be more complicated than the purchaser’s if the earn out resulted in litigation. If the performance goals are not achieved, the seller would make no additional money other than the fixed payment made on closing. If any discrepancy arises regarding the fulfillment of the performance goals, the seller may enter into endless, complex and uncertain disputes with the purchaser about these goals, or about the amount of the earn out, lowering the seller’s expected price. Second, negotiating an earn-out clause is often a thorny and heated issue, entailing higher legal fees for the seller.
Third, sellers should ensure they will have full freedom to manage the business in terms of decision-making and accessing funds, with sufficient independence to work towards achieving the performance goals. This requires the seller’s ability to prevent the purchaser from charging new costs relating to the target business, paying dividends or changing important management aspects, such as key employees or any methods used for compiling the accounts. Therefore, sellers should include specific operational covenants in the purchase agreement to preserve their potential to successfully run the target business throughout this process.
Fourth, the earn-out clause should optimally include a quantification of the damages the seller may suffer and claim if the purchaser breaches any operational covenants, such as a penalty clause or similar provision under applicable law. If the purchase agreement does not protect the seller from a potential breach by the purchaser, there is a high risk of the purchaser making decisions that would reduce the earn out, by artificially depressing or diverting revenues or earnings during the earn-out period, for example. Litigation over how much damage a purchaser’s breach has caused the seller is never simple if the purchase agreement has not established a predefined amount or penalty.
These operational covenants may include the seller’s right to keep the target company’s key employees, such as the CFO and accountants. Fifth, the seller should carefully assess the risks arising from the purchaser’s potential insolvency (that may derive from other businesses of the purchaser’s group) and problems that would occur if there is a change of control of the purchaser, or the purchaser transfers the business to a third party during the earn-out period.
Stay tuned: Part II - What advantages does an earn-out clause imply for the purchaser?