Earn-out Provisions

Kirsti Pinnell, Partner

An earn-out is essentially used to cover valuation gaps between the buyer and seller and often features in high-growth businesses where the business today is not necessarily reflective of the future value of the company. They are often negotiated as part of a share sale where the sellers are involved in the management of a company,  ensuring that an orderly handover and succession to the buyer has minimal impact on the target’s performance.  This can be in the seller’s best interests if they believe that the performance will continue to improve, even under a change of ownership, with an earn out structure designed to back up their expectations.

Earn-out provisions

An earn-out provision is a pricing mechanism where an element of the purchase price is deferred and payable subject to the future performance of the target company after completion.

Key features of an earn-out mechanism, and associated matters to consider are:

1. Confirm the final price: the earn-out mechanism will establish the final price paid for the target company and should be structured as a “win-win”, so that if performance targets are achieved the sellers are paid more with the buyer covering the additional consideration from the improved performance, and having the certainty that it should continue in the medium to long term.
2. Structure of the earn out: will depend on the nature of the target’s business and tie in with the buyer’s commercial reasons for the acquisition and perceived risks. Usually, the financial performance is based on profit or revenue, but it can be renewal of contracts or more bespoke targets depending on the commercial circumstances.
3. Protections: the sellers will want to know that the buyer cannot manipulate the financials to minimise the earn-out; whilst the buyer will not want to impede its own integration / growth plans for the target through providing the sellers with extensive protections. The protection provisions in a share purchase agreement are therefore very important to both parties and a balance has to be struck through negotiation. In practice, one of the best protections for the seller is to remain involved in the target’s management, although that may not tie in with the rationale for the sale itself.
4. Process: the detailed process of preparing and agreeing the financial information to support whether or not an earn out is payable, as well as the accounting policies and rules that must be used will be set out in the share purchase agreement, with it being agreed who will prepare the relevant information within what period and how long the other party has within which to review it and how any disagreement about them can be agreed. There are numerous considerations in relation to the process which should be covered and it is important that the share purchase agreement is as clear and detailed as possible in order to minimise the scope for costly disputes.
5. Accountants: the parties’ accountants will often be involved in the drafting and negotiating of the earn-out provisions in the share purchase agreement including in particular, any specific accounting policies that must be followed.

An earn out can be an important way to ensure pricing expectations of a buyer and seller are aligned.

We can guide you through the legal aspects of the process of a company or business sale and purchase including the pricing mechanics and work seamlessly with your accountants throughout the process of negotiating and drafting the earn out provisions.

Please contact a member of our corporate team on 0161 832 3434 if you’d like any help.