An earn-out clause enables the purchaser to close the transaction at a lower price, either by preserving cash or reducing leveraging, thus allowing the purchaser to acquire a business that would otherwise be unfeasible. Post by Pablo Cubel, partner of Cuatrecasas, Gonçalves Pereira.
Second, it retains and motivates the seller and main managers of the target business during the earn-out period. Third, it allows the purchaser to learn from the seller and managers how to run the business during the earn-out period. Fourth, it essentially protects the purchaser from overpaying for the target company and reduces the risk of losing compensation from the seller in the event of breach of the purchase agreement.
And finally, what are the disadvantages of an earn-out clause for the purchaser? The purchaser may also be affected by heated and hostile discussions arising from an, and by the risk of this tension ending negotiations or generating disputes.
However, the most frequent drawback for purchasers is that the operational covenants claimed by the seller can prevent them from satisfactorily integrating the acquired business into their own business. It is therefore crucial for purchasers to gauge whether and how they will be entitled to integrate the target business into the preexisting business once the earn-out clause has been fulfilled, without the seller running the business.
As an alternative to the traditional earn out, the purchaser could suggest a reverse earn out, based on the seller’s assurance that a given performance goal will be achieved. The risk of ending up chasing payment would, in this particular case, be borne by the purchaser.
The wording used to establish the performance goals in the purchase agreement must be clear and the performance goals must be attainable and easily measurable. These goals would normally be either a financial metric (EBITDA, net revenues or gross sales) or a specific business milestone (closing certain agreements with third parties, such as a credit agreement for a given project; obtaining the consent of third parties to assign the business to the purchaser; or completing a given procedure, such as registering a patent, completing a research project, launching a given product or obtaining a given feed-in-tariff).
If the parties have agreed to establish a specific metric, most sellers would choose one based on sales or revenues, while purchasers would prefer a metric based on net income that would encourage management to set lower costs. Most sellers prefer a metric based on sales to minimize the risk of disagreeing with the purchaser about the calculation of the parameter taken as a reference to calculate the earn out.
The easiest and most objective tactic is to establish the metric in a way that lessens any risk of discrepancy with the purchaser. It is easier to determine the amount of the gross sales than the EBITDA or profits, as these are based on interpretations that the seller and purchaser may view differently.
Another aspect that must be negotiated carefully is the earn out period and the payment schedule, namely when and how (i) the parties should verify the achievement of performance goals, and (ii) the purchaser should pay the earn-out price to the seller. Most sellers will want to shorten this period, i.e., take the money and run.
The purchaser will want to increase it, forcing the seller to stay put and prove that the business achieves the performance goals, hoping to gain more money than the seller predicted. The time frame to fulfill the performance goals would usually be established somewhere between 12 and 24 months. Depending on the nature and amount of the predefined performance goals, the parties would usually agree that the earn-out price is payable in one payment or several installments within a given period of time based on the performance goals achieved.
Two particularly sensitive payment issues should be considered: prorated payments and payments in kind. First, the parties may agree that the seller will pay the earn-out price in proportion to the level of achievement of the performance goals. And they may introduce a cap and a floor.
In this case, the parties should previously ensure that achievement is not measured only in terms of the performance goals accomplished, but also in terms of how much has been achieved. They may appoint an independent third party to measure the achievement of the performance goals if discrepancies arise. Second, the parties should define whether the seller will pay the earn out in cash or in kind and, if in kind, who and how that kind should be valued to calculate how much kind the purchaser should pay the seller.
*Read the first part of this post: What advantages and disadvantages does an earn-out clause imply for the seller?