What is an earn-out? / How does an earn-out work? / 1When is an earn-out appropriate? / The upfront payment / The contingent payment / Benefits of an earn-out for the buyer / Main benefits of an earn-out / Disadvantages of an earn-out (including an example simplified earn-out clause)
An earn-out is a contractual provision in financial transactions where a portion of the total purchase price is paid upfront, and another portion is paid post-transaction based on the performance of the target business. It is used to bridge the valuation difference between what a buyer thinks a business is worth and what the seller expects to profit.
The following are the key features in earn-outs:
- Total Purchase Price: The total amount the seller will receive for the business is agreed upon by both the buyer and the seller. This can be a fixed price paid at closing or structured as an earnout.
- Upfront Payment: In an earn-out structure, an upfront payment is agreed upon between the buyer and the seller. This is the amount that the buyer is willing to pay upfront based on their valuation of the business.
- Contingent Payment: The contingent payment is the additional payment made when the performance thresholds defined in the earn-out structure are met. It is the difference between the total purchase price and the upfront payment.
- Earnout Period: The earnout period is the defined amount of time during which the contingent payment will be made. This period is typically several years and allows the business to have a chance to succeed and meet performance metrics.
- Performance Metrics: The contingent payment is tied to specific performance metrics, which can be operational or financial. Operational metrics are used for businesses with no financial track record, while financial metrics like profit are used for businesses with an established financial track record.
- Measurement, Payment Frequency & Methodology: The contract should define how performance thresholds will be measured and when payments will be made. Payments can be made incrementally over the earnout period or as one balloon payment at the end. The methodology of measurement should also be defined.
- Target Metric and Contingent Payment Formula: A formula is used to determine the contingent payment based on the agreed performance metrics. The formula establishes a range of performance and defines how much of the contingent payment will be paid based on different levels of performance.
Earnouts are often used in the following scenarios:
- High Degree of Uncertainty: When there is a high degree of uncertainty regarding the cash flow or future performance of the target organisation, earnouts can be used to protect the buyer from the risk associated with this uncertainty. For example, in the case of a young start-up business with limited financial history or a lack of established track record, an earn-out structure can help mitigate the risk for the buyer.
- Restructuring or Change in Management: If the target business is mature and has a healthy cash flow but is undergoing restructuring or experiencing a change in management, an earn-out structure can be appropriate. This is because the buyer may have concerns about the new management's ability to maintain or improve the business's performance. An earnout can provide a mechanism to align the interests of the buyer and seller during this transitional period.
- Strategic Shift: When the target business is undergoing a strategic shift, such as introducing a new product or entering a new market, there is increased uncertainty about the future cash flow. In such cases, an earn-out structure can be used to address this uncertainty and align the purchase price with the actual performance of the business after the strategic shift.
- Talent-Intensive Industries: In industries where the value of the business is heavily dependent on key employees or client contracts, earnouts can be appropriate. This is because earnouts can be structured to incentivise talent retention and ensure that the performance thresholds continue to be met. This is particularly relevant in sectors such as investment management or technology.
- Mitigating Biases or Disagreements: Earnouts can be used to address extreme biases or disagreements between the buyer and seller regarding the valuation of the target business. If the buyer and seller have very different perceptions of the business's value, an earn-out structure can help bridge the valuation gap and provide a mechanism for the seller to achieve their desired purchase price while reducing the risk for the buyer.
An upfront payment in an earn-out structure is typically calculated based on the valuation of the target business by the buyer. The buyer determines the upfront payment based on its perception of the business's worth and their assessment of the risks involved. The calculation of the upfront payment can vary depending on several factors, including:
- Financial Track Record: If the target business has an established financial track record and is generating revenue, the buyer may consider factors such as historical financial performance, profitability, and growth rates to determine the upfront payment.
- Industry and Market Conditions: The buyer will also take into account the industry and market conditions in which the target business operates. This includes factors such as market growth rates, competition, and potential risks and uncertainties.
- Future Growth Potential: The buyer will assess the future growth potential of the target business, considering factors such as market opportunities, product innovation, customer base, and competitive advantage. This assessment will influence the buyer's perception of the business's value and, consequently, the upfront payment.
- Risk Assessment: The buyer will evaluate the risks associated with the target business, including operational risks, market risks, regulatory risks, and financial risks. The level of risk perceived by the buyer will impact the upfront payment, with higher perceived risks potentially leading to a lower upfront payment.
- Negotiation: An upfront payment is almost always subject to negotiation between the buyer and seller, taking into account their respective interests and objectives.
The contingent payment in an earn-out structure is calculated based on the achievement of specific performance metrics defined in the earnout agreement. The calculation of the contingent payment and the period for its payment can vary depending on the terms negotiated between the buyer and the seller:
- Performance Metrics: The earnout agreement will specify the relevant performance metrics that need to be met for the contingent payment to be triggered. These metrics can be operational or financial, depending on the nature of the target business and the availability of relevant data. Operational metrics might include milestones, regulatory approvals, or customer acquisition targets, while financial metrics often include revenue, profit, or EBITDA growth rates.
- Measurement and Assessment: The earnout agreement will define how and by whom the performance metrics will be measured and assessed. This could involve regular reporting, audits, or other agreed-upon methods to track and evaluate the performance of the target business. The agreement should clearly outline the methodology and criteria for determining whether the performance thresholds have been met.
- Earnout Period: The earn-out period is the defined time-frame during which the performance metrics will be evaluated. This period is typically a number of years (but could be months), allowing sufficient time for the target business to demonstrate its performance and meet the agreed-upon thresholds. The length of the earnout period is negotiated between the buyer and the seller and usually aims at giving the business a chance to succeed and not keeping key employees tied-in for an unreasonable amount of time.
- Payment Frequency: The earnout agreement will specify the frequency of contingent payments. Payments can be structured as incremental payments made over the earnout period or as a single balloon payment at the end of the earnout period. The payment frequency is determined based on the preferences and objectives of both the buyer and the seller.
- Contingent Payment Calculation: The calculation of the contingent payment is typically based on a formula agreed upon in the earnout agreement. The formula defines how the contingent payment will be determined based on the achievement of the performance metrics. The formula can be linear or exponential, and it establishes a range of performance levels and corresponding payment amounts. The specific formula will depend on the negotiated terms and the desired alignment between performance and payment.
- Adjustments: the earnout agreement should clearly outline the terms and conditions for the contingent payment, including any adjustments or provisions for unforeseen circumstances.
An earn-out structure offers several benefits to the buyer in a transaction. These benefits include:
- Risk Mitigation: By structuring the payment as an earnout, the buyer reduces the quantum of capital at risk. They only need to pay the upfront payment initially, and the contingent payment is tied to the performance of the target business. This reduces the risk of overpaying for a company that may not perform as expected.
- Alignment of Interests: An earn-out structure aligns the interests of the buyer and the seller. The seller has a financial incentive to ensure the ongoing success and growth of the target business during the earnout period. This alignment encourages the seller to actively contribute to the company's performance and increases the likelihood of achieving the desired outcomes.
- Fair Valuation: An earn-out structure allows the buyer to anchor the fair market value of the target business to its actual performance. Instead of relying solely on assumptions or projections, the buyer can tie the purchase price to the business's actual financial and operational results. This provides a more accurate valuation and reduces the need for speculative pricing.
- Retention of Key Talent: In talent-intensive industries, earnout structures can be used to retain key employees of the target business. The contingent payment may be tied not only to financial performance but also to the performance of key individuals. This ensures that the buyer retains the necessary talent to drive the company's success during the earnout period.
- Financing Mechanism: For mature businesses with stable cash flows, an earnout structure can serve as a financing mechanism. The buyer owns 100% of the business at the closing of the transaction but only pays the upfront payment initially. The contingent payments, which may not be due for years, can be financed through the dividends received from the acquired business during that time.
- Self-Selection Mechanism: The presence of an earn-out structure can act as a self-selection mechanism for the buyer. If a target business is reluctant to accept an earn-out structure, it may indicate a lack of confidence in their growth trajectory. This can serve as a red flag for the buyer, helping them identify potential risks or issues with the target business.
It's important to note that while earn-out structures offer benefits to the buyer, they also come with potential risks and challenges. These include the need for clear and well-defined ear-out terms, potential disputes over performance metrics, and the possibility of tension or litigation between the buyer and the seller.
The primary benefit of earnout structures for both buyers and sellers is that they can help bridge valuation gaps and facilitate deal completion. Here's how earnouts benefit both parties:
- Benefit for Buyers:
- Reduced Risk: Earnouts allow buyers to reduce their capital risk by paying a portion of the purchase price upfront and linking the remaining payment to the future performance of the target business. If the business underperforms, the buyer pays less, shifting the risk to the seller.
- Fair Valuation: Earnouts enable buyers to anchor the fair market value of the target business to its performance rather than relying on potentially uncertain assumptions. This helps buyers ensure that they are paying a fair price based on the actual performance of the business.
- Financing Mechanism: In cases where the target business is cash-flow positive, the buyer can use the cash flows generated by the business during the earnout period to finance the contingent payments. This provides a financing mechanism that allows the buyer to make the payments over time.
- Benefit for Sellers:
- Deal Completion: Earnouts can help break negotiation deadlocks and facilitate deal completion by bridging the valuation gap between the buyer's perceived value and the seller's expectations. Sellers may be more willing to accept an earn-out structure to achieve their desired purchase price and move the deal forward.
- Potential for Higher Purchase Price: Earnouts give sellers the opportunity to achieve their ideal purchase price if the target business performs well and meets or exceeds the specified performance thresholds. This allows sellers to potentially earn a larger profit from the sale based on the future success of the business.
- Talent Retention: In talent-intensive industries, earnouts can be structured to ensure talent retention. Sellers can tie earnout payments not only to financial or operational performance but also to the performance of key individuals in the target business. This incentivises key employees to stay with the company during the earnout period.
Overall, earnout structures provide a mechanism for buyers and sellers to align their interests, reduce risk, and bridge valuation gaps, ultimately increasing the likelihood of completing a deal.
While earn-out structures can provide benefits to both buyers and sellers, there are also potential disadvantages for sellers. These potential disadvantages include:
- Delayed Payment: Sellers typically prefer to receive their money upfront rather than waiting for contingent payments tied to future performance. Earnouts involve a deferred payment structure, which means sellers may have to wait for an extended period to receive the full purchase price. This can be a disadvantage for sellers who need immediate access to funds or have other financial obligations.
- Uncertainty and Risk: Earnouts introduce a level of uncertainty and risk for sellers. The contingent payment is dependent on the target business's future performance, which may be influenced by various factors beyond the seller's control. If the business fails to meet the performance thresholds, the seller may receive a lower payment than anticipated or no payment at all. This uncertainty can create financial and emotional stress for sellers.
- Loss of Control: In an earn-out structure, the original owners are often contractually obligated to stay with the company during the earnout period. This means they may have limited control over the operations and strategic decisions of the business. Sellers may feel a loss of autonomy and influence over the direction of the business, which can be a disadvantage for those who value independence.
- Disagreements and Litigation: Earnouts can lead to disagreements and potential litigation between the buyer and the seller. Disputes may arise regarding the measurement and assessment of performance metrics, the calculation of the contingent payment, or the fulfillment of contractual obligations. These conflicts can be time-consuming, costly, and strain the relationship between the parties involved.
Limited Upside Potential: In some cases, earnouts may cap the potential upside for sellers. If the earn-out structure sets a maximum contingent payment amount, sellers may not fully benefit from the future success and growth of the target business beyond that cap. This can be a disadvantage if the business significantly outperforms expectations during the earnout period.
Example: Simplified Earn-Out Provision
3. Earn-out Consideration
3.1 In addition to the Initial Consideration of £[x] paid on Completion, the Buyer shall pay to the Seller a further contingent consideration of up to £[Y] (the "Earn-out Consideration"), calculated as follows:
3.1.1 If the Net Profit of the Company for the [3] year period commencing on the Completion Date (the "Earn-out Period") is equal to or greater than [100]% of the Net Profit of the Company for the [12] month period immediately preceding the Completion Date (the "Base Net Profit"), then the Earn-out Consideration shall be £[Y].
3.1.2 If the Net Profit of the Company for the Earn-out Period is less than [100]% of the Base Net Profit, then the Earn-out Consideration shall be reduced proportionately on a straight-line basis.
3.2 The Earn-out Consideration (if any) shall be paid by the Buyer to the Seller within [30] days of the determination of the Net Profit of the Company for the Earn-out Period in accordance with clause 3.3.
3.3 Within [60] days after the end of the Earn-out Period, the Buyer shall prepare and deliver to the Seller a statement (the "Earn-out Statement") setting forth its calculation of the Net Profit of the Company for the Earn-out Period and the resulting Earn-out Consideration (if any) payable to the Seller pursuant to clause 3.1.
Defined terms:
"Base Net Profit" means the Net Profit of the Company for the [12] month period immediately preceding the Completion Date, as shown in the Company's audited accounts for that period.
"Completion Date" means [date].
"Net Profit" means the net profit of the Company calculated in accordance with [UK GAAP/IFRS] and consistent with the accounting policies, practises, principles and methodologies used in preparing the Company's audited accounts for the [12] month period immediately preceding the Completion Date.
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