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Earn-out consideration: potential issues and how to avoid them

Picture of Adam McKenna

By Adam McKenna

1 Nov 2023 | 1 minute read

What is an earn-out?

An acquisition will typically be structured where a proportion of the purchase price is paid on completion, with a balance to be paid at certain stages in the future.

This additional consideration will often be measured against the future performance of the target business (e.g. financial or performance milestones); the better the business performs, the more consideration is payable to the seller.

By linking the consideration to future performance, it provides buyers with additional protection to navigate through a transitional period for the business. It also benefits sellers whose consideration would be higher as opposed to all consideration being paid up front (subject to satisfaction of the performance conditions).

Key issues

At its most fundamental, there is an inherent conflict between the buyer and seller in an earn-out. A seller will want to maximise the earn-out (possibly without regard to the longer-term success of the business) whereas a buyer will want to minimise its cost for the target (whilst still having a successful business).

As such, earn-outs could create an incentive for either party to engage in unethical behaviour. For example, each party may be motivated to manipulate financial statements in order to ensure that the performance milestones are met or missed (as appropriate). Even in less ‘sharp’ situations there’s commonly tensions such as whether revenue is exceptional or repeating and should or should not count towards, for example, EBITDA triggers.

Earn-outs can also be difficult to manage and track. The buyer and the seller must agree on specific financial or performance milestones, and they must have a mechanism in place to measure and track these milestones. This can be difficult, especially if the target has complex operations or multiple business units.

As is common in many PE bolt-on acquisitions, a buyer may also want to integrate the target business into its wider group to realise synergies and to drive efficiencies, which can make it hard to track individual performance of the target. Very commonly those benefitting from earn-outs have a vested interest in maintaining the separate economic identity of the target business and can resist and slow down the required synergies.

If the terms of the earn-out are unclear, it can be challenging to determine whether the performance milestones have been met in a fair and objective manner.

The buyer and the sellers will have directly competing interests – to either minimise or maximise the earn-out. Obviously, there are other considerations and factors at play, but it is no surprise that earn-outs often result in heavily litigated arguments which can push fragile relationships over the edge.

Practical steps to consider

As earn-outs are conditional on certain measurables being achieved, it is important that any room for doubt is expelled by being absolutely clear on how these metrics are measured. What accounting principles are being applied? What specific policies or treatments should take priority? What revenue is or isn’t included? What about target sales generated from buyer relationships?

Ensure that the terms are specific, measurable and achievable to avoid any future disputes. Consider establishing a mechanism to measure and track the performance milestones, for example regular financial statements and operational reports. Make sure you comply with those mechanisms to the letter.

An area that is often overlooked by lawyers is what happens following completion of a transaction. Completion of an acquisition is just the beginning of a journey, and a buyer may want to quickly integrate a target business into its wider group to ensure alignment with its culture and values.

However, this harmonisation process is often heavily restricted by what the buyer can and cannot do in respect of the business during the earn-out period (see below). As such, it’s essential that the buyer has a clear acquisition strategy which should be formulated well in advance of binding bids being approved. If integration and realisation of synergies are a prime focus, then this may need to be factored into restrictions and/or performance milestones to avoid tensions and potential disputes.

Don’t forget that most businesses are only as good as their people so it’s important for a buyer to do its due diligence not only on the financial and legal aspects of the deal, but to understand the relationships and dynamics within the business. This will assist in formulating a clear plan for events post-acquisition, which works alongside the business restrictions to minimise the potential conflict between the sellers and the buyer. Ensure objectives and key strategies are clearly communicated with stakeholders, which will allow greater transparency to further align the business and common goals.

A purchase agreement will often contain a large number of restrictions on what the parties can do during the earn-out period to avoid any manipulation of the performance measurables. It is important that these are restrictive enough to prevent unconscionable behaviour, whilst also giving enough flexibility to ensure the business can thrive.

It is very often the case that likely failure to hit earn-out triggers can be forecast well ahead of time. A buyer can plan for, and pre-empt, disputes before they arise and prevent disruption through a range of measures, ranging from renegotiating/creating fresh and new incentives, negotiating earlier exits to avoid the cost and disruption of disputes, etc.

A buyer will often want assurances and certainty that a manager seller will continue to be involved in the business post-completion, rather than taking their consideration and sailing off into the sunset. Protections can be sought by requiring a manager seller to remain in the business in order for their earn-out consideration to be paid.

Caution is advised here, and tax advice should always be sought to avoid these restrictions inadvertently causing the earn-out consideration to be categorised as employment income in the hands of the sellers (resulting in an increased tax charge for both the seller and the target company).

Practical steps to consider

As earn-outs are conditional on certain measurables being achieved, it is important that any room for doubt is expelled by being absolutely clear on how these metrics are measured. What accounting principles are being applied? What specific policies or treatments should take priority? What revenue is or isn’t included? What about target sales generated from buyer relationships?

Ensure that the terms are specific, measurable and achievable to avoid any future disputes. Consider establishing a mechanism to measure and track the performance milestones, for example regular financial statements and operational reports. Make sure you comply with those mechanisms to the letter.

An area that is often overlooked by lawyers is what happens following completion of a transaction. Completion of an acquisition is just the beginning of a journey, and a buyer may want to quickly integrate a target business into its wider group to ensure alignment with its culture and values.

However, this harmonisation process is often heavily restricted by what the buyer can and cannot do in respect of the business during the earn-out period (see below). As such, it’s essential that the buyer has a clear acquisition strategy which should be formulated well in advance of binding bids being approved. If integration and realisation of synergies are a prime focus, then this may need to be factored into restrictions and/or performance milestones to avoid tensions and potential disputes.

Don’t forget that most businesses are only as good as their people so it’s important for a buyer to do its due diligence not only on the financial and legal aspects of the deal, but to understand the relationships and dynamics within the business. This will assist in formulating a clear plan for events post-acquisition, which works alongside the business restrictions to minimise the potential conflict between the sellers and the buyer. Ensure objectives and key strategies are clearly communicated with stakeholders, which will allow greater transparency to further align the business and common goals.

A purchase agreement will often contain a large number of restrictions on what the parties can do during the earn-out period to avoid any manipulation of the performance measurables. It is important that these are restrictive enough to prevent unconscionable behaviour, whilst also giving enough flexibility to ensure the business can thrive.

It is very often the case that likely failure to hit earn-out triggers can be forecast well ahead of time. A buyer can plan for, and pre-empt, disputes before they arise and prevent disruption through a range of measures, ranging from renegotiating/creating fresh and new incentives, negotiating earlier exits to avoid the cost and disruption of disputes, etc.

A buyer will often want assurances and certainty that a manager seller will continue to be involved in the business post-completion, rather than taking their consideration and sailing off into the sunset. Protections can be sought by requiring a manager seller to remain in the business in order for their earn-out consideration to be paid.

Caution is advised here, and tax advice should always be sought to avoid these restrictions inadvertently causing the earn-out consideration to be categorised as employment income in the hands of the sellers (resulting in an increased tax charge for both the seller and the target company).

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