Earn-out Structures - M&A Deals

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💡 What is an Earn-Out Agreement?

An earn-out agreement is a strategic payment mechanism that allows part of the purchase price in an M&A deal to be contingent upon the future performance of the acquired business.

In volatile economic conditions, it can be a win-win, enabling the seller to benefit from future growth while protecting the buyer from overpaying upfront. However, for an earn-out to be effective, the agreement must be meticulously drafted in the SPA to ensure both parties are aligned on how the performance targets will be measured and achieved.

A well-structured agreement with clear, mutually understood terms not only minimizes the potential for disputes but also creates a framework for accountability. Explicitly defining the metrics, timelines and responsibilities helps reduce ambiguity and minimize the risk of manipulation, ultimately fostering trust between buyer and seller.

Figure 1 - Earn-Out Simplified Structure

📃 Key Considerations in Earn-out Agreements

Earn-out agreements can be a smart way to bridge valuation gaps and manage risk, but like any deal, they need careful handling to avoid hiccups down the line. From defining measurable metrics to negotiating control post-closing and tackling tax implications, getting the details right is crucial.

Earn-outs can be structured around a range of conditions such as hitting a pre-agreed net profit for a specific year and/or reaching a set percentage of product-line growth. Thoughtful planning and a clear understanding of these areas will go a long way in preventing misunderstandings and keeping both parties on the same page.

Here’s what to keep top of mind when structuring an earn-out agreement:

1. Clear and Measurable Metrics

Metrics like EBITDA, revenue, or customer retention often drive whether an earn-out payment gets triggered, but they need to be rock solid in the agreement. Vague or loosely defined terms can quickly turn into legal battles post-closing, as we've seen in several recent cases. It’s worth sweating the details here to avoid unnecessary headaches later.

2. Negotiating Control Post-Closing

Buyers usually want free rein to run the company after acquisition, but that can sometimes interfere with the seller’s ability to hit earn-out targets. Sellers should negotiate for some control or at least ensure the buyer can’t make moves that unfairly reduce the earn-out potential. Striking the right balance here is key to safeguarding the seller’s interests.

3. Be Cautious with Long Earn-Out Periods

Longer earn-out periods give sellers more time to hit performance goals, but they also expose them to market forces that no one can predict. Most earn-outs run between one and three years, but given today’s unpredictable market, you’ll want to think twice about how long you’re on the hook for those targets.

4. Tax Implications

The tax side of earn-outs can get complicated fast for both sides. Depending on how it’s set up, an earn-out could be treated as employment income, capital gains, or even stir up extra taxes like stamp duty. Both buyers and sellers should sit down with tax pros to iron out the details and build the agreement in a way that minimizes tax exposure.

5. Dispute Resolution Mechanisms

With the potential for disputes high in earn-out agreements, it’s critical to have a plan in place for resolving any disagreements. This could include bringing in expert determination or setting up alternative dispute resolution mechanisms to handle issues with payment calculations. Laying out these procedures in the SPA can save both parties a lot of trouble down the road.

📈 Why are Earn-out Provisions on the Rise?

Earn-out provisions have seen a solid rise, jumping from the 20-30% range pre-2020, to 43% in 2022, before dropping slightly to 37% in 2023. With inflation rising, interest rates tightening, and credit harder to come by, it’s no wonder both buyers and sellers are leaning on these provisions to keep deals moving.

Earn-outs seem particularly useful in today’s economy due to:

Bridging Valuation Gaps

Sellers tend to have high hopes for their company’s future, while buyers are wary of overpaying upfront due to financing costs and market uncertainties. Earn-outs strike a balance by tying part of the purchase price to future performance, making it easier for both sides to agree on a deal.

Risk Allocation

Earn-outs shift some risk to the seller, ensuring buyers don’t overpay upfront in a shaky market. By making part of the payment contingent on hitting performance goals, buyers can protect themselves against overpaying.

Keep Deals Moving

In a tough economic climate where credit is tight, earn-outs make it easier to close deals without requiring the full cash payment upfront. They allow transactions to proceed without the buyer needing all the cash on day one.

Aligning Interests

Earn-outs encourage sellers to stay involved after the deal closes, focused on hitting key performance milestones. This not only helps with the transition but keeps everyone aligned toward the company’s success.

Upside Potential for Sellers

For sellers who believe in the company’s future success, earn-outs offer a shot at higher payouts if the business exceeds performance targets. It’s a chance for them to share in the growth they’re confident about.

Flexible Payment Structure

Earn-outs give buyers more flexibility by deferring part of the payment, which helps with cash flow. This setup spreads out the financial impact over time, easing the initial cash burden.

✒ On a Final Note…

Earn-out agreements are a powerful way to close deals in uncertain markets, offering a solution that aligns both buyer and seller interests while safeguarding the transaction’s success.

As we head further into 2024’s volatile economic landscape, expect earn-outs to remain a staple in M&A strategies. If you’re working through an M&A deal, don’t gloss over those earn-out clauses — carefully crafting the details upfront can save you from expensive disputes down the line.

Until next time,
PE Bro 

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