Structure of an earn out
The terms of an earn-out mechanism should be clearly set out in the share purchase agreement, and address each of the following points:
- The benchmark against which the company's performance will be measured.
- How performance against the chosen benchmark will be calculated. The parties may also consider whether any maximum or minimum limits on the ultimate purchase price should be imposed.
- The length of the 'earn-out period', ie. the period of time for which the company's performance is to be taken into account for the purposes of any calculation.
- How the company's accounts should be prepared (as this may have an effect on the ultimate purchase price).
- How and when earn-out payments are to be paid, as well as whether any interest should be payable on late payments.
- The dispute resolution process to be followed by the parties in the event that any disagreements arise (for example, in relation to how any earn-out payment has been calculated, or how accounts have been prepared).
- The terms of any continuing seller involvement. It is important that the parties are clear as to what the responsibilities of each party are, and the limits of their authority (this will help ensure that decisions can be made efficiently).
- How the company is to be managed during the earn-out period, and whether there are any restrictions to be placed on the buyer's ability to make structural changes. A seller in particular will want to protect themselves against any attempt by the buyer to manipulate or negatively influence the purchase price and ensure that both parties' interests are aligned.
Selecting a benchmark
A buyer and a seller can select from a number of benchmarks against which to measure the target company's future performance. Most commonly, financial metrics are used, for example, profits, EBITDA, revenue, or earnings per share. That said, depending on the nature of the deal, the parties might prefer to select a different target, for example number of units sold (generally this target may be used if there is limited historical information from which to forecast future financial metrics).
Whichever benchmark is selected, it is critical that the parties clearly define within the share purchase agreement the benchmark against which the target company's future performance will be measured (as well as how it will be measured). A poorly defined benchmark can lead to disputes further down the line. For a detailed consideration of the potential issues that might arise when earn outs are used, please see here.
In times of economic uncertainty, we generally see a rise in earn-out mechanisms being used. The reason for this is that it can be more difficult to predict the value of a company where its recent performance has been impacted by an unusual event – the pandemic was a good example of this. Earn-out mechanisms can help prevent a deadlock between the buyer and the seller in these situations and help push a deal 'over the line' despite differences in views over a company's value.
Alongside a rise in earn-out mechanisms being used, however, we also see a rise in earn-out disputes. Parties lose sight of the fact that earn-out mechanisms in effect delay the determination of the value of the company, and do not spend enough time considering the impact of the way in which the earn-out mechanism is drafted. A common example is where the benchmark chosen by the parties against which performance is measured reacts disproportionally to a wider external event (for example, demand for a particular product decreasing as a result of the introduction of regulatory measures disproportionally impacting unit sales).
Earn-out mechanisms can be a useful tool in circumstances where parties are unable to agree on a fixed purchase price, or where a buyer requires a level of continuing involvement from the seller's management. As discussed above, however, whilst we are experiencing a rise in earn-out mechanisms being used, we are also seeing a rise in disputes as a result of poor drafting and improper levels of consideration being given to these by the parties. Specialist advice should therefore be sought to ensure that any earn-out mechanism functions as intended.
If you would like to discuss any of the issues explored in this article in more detail, please contact a member of our team on the contact details below.