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. 

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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
Kristen Lee
| ASSOCIATE ATTORNEY

Kristen Lee is an associate attorney at Parsus  LLP.  Her 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. Prior to joining Parsus, Kristen represented corporate clients in high-stakes litigation involving breach of contract, fraud, unfair competition, and other business torts.  

Kristen is a member of the Korean American Bar Association of Southern California.

Kristen received her B.A. degree from the University of Texas at Austin and her J.D. degree from Pepperdine School of Law.  Kristen is fluent in Korean. 

EVELYN SHIMAZAKI
| OF COUNSEL

Evelyn Aguilar Shimazaki is Of Counsel at Parsus LLP. Her practice is focused on the representation of technology companies in intellectual property licensing and commercial transactions, including joint development, manufacturing, procurement, strategic alliances, outsourcing and other services arrangements. Prior to joining Parsus LLP, Evelyn was a Senior Counsel at Apple in Cupertino, California for fourteen years. After Apple, she joined Tesla in Palo Alto, California as Chief Counsel and more recently, Oculus VR, a division of Facebook in Menlo Park, California as a Consultant.  

Evelyn is a Founding Board Member of UCLA Law Women LEAD, an Advisory Board Member of the Lowell Milkin Institute of Business Law and Policy at UCLA School of Law, and a past President and Advisory Board Member of the Philippine American Bar Association of Los Angeles.

Evelyn received her B.A. degree from the University of California, Berkeley and her J.D. degree from UCLA School of Law. A native of the Philippines, Evelyn speaks Tagalog, Spanish and some Japanese.

Ju Park
| MANAGING & FOUNDING PARTNER

Ju is a corporate lawyer by training and an entrepreneur at heart.  After attending the United States Military Academy at West Point for a year where she gained essential life skills including throwing grenades and applying a tourniquet, she graduated from McCombs Business School at the University of Texas majoring in finance.  Ju then graduated from UCLA School of Law where she focused her studies on International Business Law.  After law school, she practiced corporate law and litigation in the Los Angeles and Hong Kong offices of an international renowned law firm, Latham & Watkins, where she advised domestic and foreign clients, including Fortune 500 companies, on various corporate matters including general commercial contracts, corporate finance, IPOs and mergers and acquisitions.

Ju co-founded Parsus in 2009 with a vision to transform the legal services industry to make quality legal advice more available to and affordable for businesses of all sizes while improving the lifestyle and overall happiness of lawyers.  Over the years, and particularly since recently becoming a mother, Ju’s vision for Parsus has expanded to transform our extended community by committing a part of the firm’s profits and resources for charitable purposes.

In her role at Parsus LLP, Ju serves as outside transactional and general counsel to clients of all sizes and across a broad range of industries.  Her clients include domestic and foreign companies to whom she provides practical and cost-effective solutions to their general day-to-day business legal matters as well as major transactions such as mergers and acquisitions, corporate finance and cross-border transactions.  Ju combines her legal expertise with her business acumen to provide practical solutions to her clients’ legal issues without “over-lawyering” their contracts or deals.  Ju’s recent clients have included foreign and US companies acquiring and/or investing in US companies or assets, US companies receiving foreign and domestic investments, US subsidiaries of foreign companies going public, and foreign companies with ongoing US operations.  Ju also enjoys working with like-minded entrepreneurs and start-up executives.