What is an Earn Out

In the context of company mergers and acquisitions, an earn-out is a mechanism whereby part of the purchase price for a company (“Company”) is dependent on the Company’s performance following completion of the sale.  

Earn-outs can be popular with buyers because they only have to pay the full price for the Company if it achieves certain financial targets. Sellers can be persuaded to sell on this basis because they have the opportunity to benefit from the potential growth of the Company after they have sold it.

However, earn-outs are not straightforward and both parties should focus on the detail of how that performance will be achieved and measured.

Terms of the earn-out

The terms of an earn-out will typically be included in the main share purchase agreement (“SPA”). If an earn-out is to be included in the SPA, the terms governing the earn-out are generally highly negotiated. The seller wants terms which increase their chance of receiving the maximum earn-out payment, which is likely to focus on the Company’s performance in the short-term. The buyer will want the freedom to run the Company as they wish, often focusing on maximising value in the medium to long term.

The key terms of an earn-out will be:

(1) the financial performance metric and targets on which the earn-out is based and how that will be calculated in the earn-out accounts; and

(2) how the Company will be operated during the earn-out period.

Typically earn-outs will be measured and calculated by reference to the financial performance of the Company, often using a calculation of profitability, such as EBITDA (earnings before interest, taxes, depreciation and amortisation). It is important to establish which costs, including any group management charges (if the Company forms part of the buyer’s group of companies), are to be considered when calculating the EBITDA. For example, if the Company incurred significant recruitment costs in the final 6 months of the earn-out, that would reduce the Company’s EBITDA, but the new recruits would not benefit the Company's performance until after the end of the earn-out period. Those recruitment costs could, therefore be excluded from the EBITDA calculation.

Earn-outs are often used when a seller is selling the Company but is remaining with the Company in some capacity. In this situation, the earn-out acts as an incentive for the seller to maximise company performance. However, the seller will have been used to having full autonomy on how the Company was operated when it was under their sole ownership. The buyer will want to benefit from the seller’s ongoing involvement in the business, but the will want ultimate control. There is the risk for the seller that business will be diverted away from the Company to other members of the buyer’s group. The seller will therefore want to negotiate certain protections that govern the conduct of the Company during the earn-our period, such as:

1. the buyer will ensure that the Company will only contract with other members of the buyer’s group on arm’s length terms;
    
2. the buyer cannot make any material changes to the business of the Company without the seller’s agreement;
    
3. the buyer will not divert business away from the Company to another company in the buyer’s group and no member of the buyer’s group will compete with the Company; and
    
4. the buyer will use reasonable endeavours to maximise the Company’s profits.

How we can help you

On a company sale or purchase, our team of lawyers can work with your accountants and advise you on how best to structure an earn-out to ensure the best outcome for you and/or your company.

Call 01242 574244 or contact us to find out how we can help with the sale of your company.