The uncertain economic climate is leading more business owners to exit by selling their shareholding based on deferred consideration. Often these deferred payments are conditional on the business performance after completion otherwise known as “earn-outs”. Such arrangements can lead to disputes however and it is important for both parties – buyers and sellers – to enter them with their eyes open.
Buyers often use earn-out arrangements to bridge the gap between what they are prepared to pay and what the seller believes his business is worth. Essentially, the buyer is asking the seller to “put their money where their mouth is” in relation to their forecast of how the business will perform. It also has the advantage for the buyer that it reduces the cash the buyer has to find upfront and effectively gets the business to pay for itself.
“An earn-out arrangement can provide an attractive solution for buyers and sellers alike.”
An earn-out arrangement can provide an attractive solution for buyers and sellers alike. The seller benefits from an up-front payment and the promise of further payments dependent on the performance of the business over time. The buyer benefits from only paying further sums if the business performs, when, you would hope, the business has generated the cash to pay for itself.
Finding the middle way
When negotiating the terms of an earn-out arrangement, it is important for both sides to be realistic and that they should be prepared for a difference of opinion. It is not unusual for there to be a discrepancy in the expectations of buyers and sellers: the sellers will be looking at business decisions on a short-term basis as they just wish to maximise their earn-out payments.
For example, the seller may be against investing in a new product which may cost a lot in the short term but in the long term will generate more sales and strengthen the firm’s market position. The buyer, on the other hand, will look at the business and how its run from a long-term perspective and will wish to make decisions on that basis. The earn-out arrangement can help to bridge this gap in expectations, by agreeing to make payments to the seller based on clearly-defined targets, such as annualised turnover figures or profits, but also setting out what the buyer can and can’t do with the business during the period of the earn-out.
“The earn-out arrangement can help to bridge a gap in expectations by agreeing to make payments to the seller based on clearly-defined targets.”
Disputes can arise for a variety of reasons but tend to occur more frequently if business performance turns out to be not as strong as expected. A buyer is less likely to argue the detail of the earn-out payment if the business is performing strongly. The seller should have the appropriate provisions in the agreement to allow them to monitor the performance of the business closely if they are not going to remain with the business during the earn-out period. They do however need to recognise there is a risk that, whether or not they are involved, the earn-out may not be paid. Therefore the seller should ensure they are happy with their up-front payment, regardless of whether future payments are forthcoming or not.
There can also be differences of opinion over the way that targets set out in the agreement have been calculated. For example, it is usually preferable to ensure that future payments are payable based on turnover rather than profits, as the latter can be manipulated more easily. If the buyer insists on future payments being dependent on profits, it needs to be clear how those profits are calculated. Also, the seller should be able to negotiate certain adjustments that must be made to the profit figure to ensure it accurately reflects the position that the target was based on. However, profit-based targets will generally carry more risk for the seller.
Other disputes can arise if the performance of the business is borderline or just slightly trailing expectations, which could encourage the buyer to delay signing a big customer contract during the earn-out period in order to avoid triggering the seller’s payment.
With any form of deferred payment, on an earn-out basis or not, the seller must understand that they are taking a credit risk on the buyer and whether it will be able to pay the future consideration. There is various security that the seller can take to try to protect himself, including, on smaller deals, personal guarantees.
The attractiveness of earn-out agreements
Earn-out agreements can provide an excellent solution for businesses where a shareholder is keen to realise value but the proposed buyer either cannot raise sufficient finance to pay the whole consideration upfront or there is a difference of opinion over the value of the business.
Inevitably, a sale involves lots of changes which can be disruptive for employees, customers and create tension during the earn-out period. The tension between the short-term aspirations of the seller to get his full earn-out paid and the buyer who wants a successful business for the future can be tempered by properly drafted earn-out arrangements.
However, fundamentally, the seller should ask themselves at the outset: ‘would I trust the buyer to run the business as well as I do?’ If the answer is ‘yes’, an earn-out arrangement could be the right solution for the buyer and the seller.
Keith Spedding is a partner and corporate finance specialist at Shakespeare Martineau.