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.