Earn-Outs in M&A Transactions

What is an Earn-Out?

An earn-out is a risk-allocation mechanism used in M&A transactions whereby a buyer’s obligation to pay part of the purchase price is deferred until after the closing.  An earn-out payment is contingent on the future performance of the target company.  

When do Parties use an Earn-Out?

An earn-out system can be helpful in bridging a valuation gap.  It’s common for parties in an M&A transaction to disagree on the value of a business.  For example, a seller may believe that the target company is worth $20M, which is more than its current value, because it has huge growth potential due to new product launches, or because the target company is experiencing a temporary set-back but is expected to bounce back soon.  The buyer, on the other hand, may believe that the target company is only worth $12M because it does not have such an optimistic view of the target company’s future, especially when the target company is a startup and there is insufficient financial history to accurately forecast future growth.  This sort of difference in valuation is when an earn-out can be helpful.  The parties can set the purchase price at $20M, but incorporate an earn-out system so that the payment on the difference in valuation ($8M) is contingent on the target company’s future performance.

An earn-out system can also help resolve buyer’s financing issue, such as when a buyer lacks funds to pay the full purchase price upfront and is unable to get a loan or other types of financing in time for the closing.  An earn-out system gives the buyer time and opportunity to pay the rest of the purchase price.

What are the Advantages of an Earn-Out?

From a buyer’s perspective, an earn-out can protect the buyer from overpaying, since part of the purchase price depends on the actual future performance of the target company rather than basing the entire value of the target company on past performance and estimated future performance.

An earn-out can also be advantageous to a buyer if the purchase agreement allows the buyer to offset its indemnification claims against the seller with the earn-out payment.  It’s often easier for a buyer to withhold earn-out payments to satisfy the seller’s indemnification obligation than to get money from the seller.

From a seller’s perspective, an earn-out can provide an opportunity to set a higher purchase price.  For example, without an earn-out option, the buyer may insist on a lower purchase price, basing the target company’s value solely on its past history and current value.  Or, as previously mentioned, the buyer may not have sufficient cash flow to pay the higher purchase price, so the parties are forced to settle for a lower purchase price.  Looking for another buyer may not always be easy or cost effective. 

What are the Disadvantages of an Earn-Out?

In general, an earn-out is more disadvantageous to sellers than buyers.  Most sellers want a clean break from the target company post-closing, but an earn-out may force the seller to stay engaged in the operations of the target company, or to continue to monitor the company’s performance, since the earn-out payment depends on the target company’s success.  Another disadvantage is that a buyer may withhold earn-out payments as they become due if the buyer believes that they are owed some form of compensation from the seller, such as an indemnification obligation.

From a buyer’s perspective, an earn-out can be disadvantageous in that the seller might seek to limit the buyer’s ability to make significant changes to the target company.  Any buyer would want the freedom to run its company without restriction, but it’s possible that an ongoing earn-out obligation could deny the buyer that freedom.

Including an earn-out obligation should be considered carefully, because the profitability of the target company can be affected by many factors that are outside of the parties’ control, such as economy, and it can also increase the possibility of post-closing disputes.

Although an earn-out can help parties to close a deal in certain situations, each transaction is unique and an earn-out may not be the most effective solution to your transaction.  Therefore, it is advisable that you speak to an experienced and qualified attorney to structure your specific transaction. 

Legal Disclaimer: The  information in this article is provided for general informational and educational purposes only.  It is not intended to be legal advice and does not create an attorney-client relationship. 

Leave a Reply

JAE EN (JEN) KIM  | SENIOR COUNSEL

Jen Kim is Senior Counsel at Parsus LLP. Jen specializes in cross-border M&A, investment and financing transactions. She brings a wealth of cross-border legal experience and cultural knowledge to facilitate multinational clients doing business in Asia and the U.S.

Jen is an English-Korean bilingual corporate attorney who spent the first 8 years of her career at big law firms, initially in the Chicago office of Drinker Biddle & Reath then at Kim & Chang in Seoul, Korea. At Drinker Biddle & Reath, her practice focused on transactional work including M&A, private equity and partnership investments. At Kim & Chang, in addition to transactions, she worked on a broad range of matters for multinational clients in the life sciences, healthcare and chemical industries, serving as the outside general counsel for their operations in South Korea and the broader Asia Pacific region.

Most recently, Jen was in-house at Reckitt Benckiser, a global consumer health company with well-known consumer brands such as Lysol, Mucinex, Air Wick and Enfamil.  At Reckitt Benckiser, she was a member of the senior management team looking after all legal and compliance matters for its Korea and Japan businesses before transitioning to her role in Chicago where she managed the integration of the company’s newly acquired infant formula business and led the North America health business in data privacy matters.

Jen majored in business administration at Ewha Womans University and received her J.D. degree from Northwestern University Pritzker School of Law.

David Kim | PARTNER

David Kim is a Partner at Parsus LLP.  He specializes in corporate and technology transactions, with an emphasis on intellectual property.  David has represented a variety of clients from start-ups to Fortune 500 companies in mergers and acquisitions, cross-border investment, financing, and licensing.  His clients do business in a range of industries including entertainment, financial services, consumer products, gaming, software, and technology services. 

 

Prior to returning to Parsus LLP, David served as an in-house intellectual property counsel for NBCUniversal, advising on technology and mergers and acquisitions for the various business units of the company.  He assisted the company’s corporate development teams in assessing acquisition targets and negotiated NDAs, vendor service agreements, software and hardware licenses, and trial agreements for experimental and prototype technology.  David was also one of the company’s primary resources on open source software-related matters.    

 

Before joining NBCUniversal, David co-founded and served as a Partner of Parsus LLP, worked as in-house counsel for start-ups, and was an associate at Winston & Strawn, where he represented clients in intellectual property matters including patent assessment and analysis, IP licenses, and various phases of patent and copyright infringement litigation.  At Winston, David also represented clients in general business and securities litigation concerning commercial disputes and business torts.

Kristen Lee
| ASSOCIATE ATTORNEY

Kristen Lee is an English-Korean bilingual corporate associate attorney at Parsus LLP.  With a background in defending corporate clients in high stakes litigation, Kristen’s current practice is focused on commercial transactions and the various day-to-day legal needs of businesses of all sizes, including business formation, corporate governance, commercial contracts, and mergers and acquisitions.  

In her role at Parsus, Kristen has represented numerous public companies operating in the US including NHN and CJ. Her recent transactions include representing a group of foreign investors in a minority investment of a US software start-up and representing a Korean company acquiring a US digital media company.

Ju Y. Park, Esq.
Ju Park
| MANAGING & FOUNDING PARTNER

Ju Park is the Managing and Co-Founding Partner of the Firm, and practices in the areas of mergers and acquisitions, corporate finance, corporate governance and general corporate transactions. She also has considerable experience working with companies as their offsite general counsel in providing practical and cost-effective solutions to their general day-to-day business legal matters.

In the area of securities, Ju has represented issuers and investment banks in initial public offerings, private placements of debt and equity securities, 144A securities offerings, foreign public offerings and private equity transactions. Ju’s experience spans a wide array of clients and industries, including individuals, start-ups and Fortune 500 companies with a presence in the food, cosmetics, sports, entertainment and media, real estate and e-commerce industries. Ju also has experience assisting NYSE and NASDAQ-listed companies with public reporting obligations and general corporate compliance matters.

In the area of mergers and acquisitions, Ju has represented both public and private companies on sell-side and buy-side transactions. Ju’s experience in mergers and acquisitions include complex, cross-border deals involving collaboration with foreign counsel in multiple countries.

Before co-founding Parsus, Ju was an attorney in the Hong Kong and Los Angeles offices of Latham & Watkins.