Why earn-out agreements can be advantageous for both buyers and sellers

Earn-outs are a frequent point of contention in the company acquisitions industry; they can be an incredibly useful tool for both acquiring and disposing of a business but the risks inherent in employing an earn-out can occasionally make them as problematic as they can be advantageous.

Where earn-outs stand out as an immensely valuable approach is in bridging the gap in expectations between a buyer and a seller; in many cases they have been the prime facilitator to allow a sale to take place at all, or they have played a vital role in ensuring that a sale went through to the right buyer.

Here we look at the potential pitfalls and advantages of an earn-out for both buyer and seller and how to make sure an earn-out is useful.

What is an earn-out?
Earn-outs are provisions within purchase agreements, or in some cases separate agreements within a merger or acquisition's financial documentation. Stipulating that a percentage of the purchase price will be dependent on whether or not the acquisition reaches pre-determined benchmarks or milestones during a specified period after the handover.


Let’s say a chain of cycle shops has a £2.5 million asking price, based on historic earnings and projected revenues. But the buyer can only get immediate access to £2 million. The seller is expecting to negotiate, but is not prepared to drop 20 per cent.

So rather than each walking away from the deal, the two parties sit down and come up with a plan whereby the seller is to be paid £2 million upon signing, and receive three payments of £100,000 at the end of each of the next three years. These payments will only get paid if (for example) annual gross sales are at least at forecast level, i.e. £10 million per year.


Why choose an earn-out?
An earn-out provides a means of ensuring a business sale happens. In some cases, without an earn-out, a deal will not get done at all. Having one in place as an option means that a buyer does not have to front up all the cash immediately – instead they are able to use the business to effectively pay for some of its own purchase costs.

Benefits for a buyer
• Much of the uncertainty in the value of the business can be alleviated
• Reduces the amount of finance required prior to purchase
• Should the seller remain with the company, the buyer may benefit from his or her experience.

Risks for a buyer
• The earn-out calculations could be manipulated by a seller
• Seller may focus on short-term profits at the risk of the firm's long-term success
• Integration can be challenging with effectively two 'bosses' onboard.

Benefits for a seller
• Chance to realise greater value from the business sale
• Certain level of control over business direction post-sale
• Potential to attract desired 'calibre' of buyer, particularly in a 'buyer's market'.

Risks for a seller
• As for a buyer, there is a risk that the opposite party could manipulate earn-out calculations
• Potential for buyer to limit seller's control over business operations during crucial earn-out period
• Chance that business interests will clash, posing a risk to earn-out targets.

Is there such a thing as a standard earn-out structure?
There are ways to ensure that neither buyer nor seller is left out of pocket when an earn-out is in place. Firstly, most people will want to keep the earn-out between one and three years in length. Much shorter, and the buyer may find themselves short-changed if the seller is inclined to focus on short-term gains rather than the firm's long-term success. Much longer, and, from the seller's perspective, there are simply too many unforeseen circumstances to agree realistic targets.

In terms of the percentage of the price paid upfront and the percentage assigned to the earn-out, this will depend on the circumstances of the business. In some cases, a 50/50 split will be used, but in most situations a seller will be looking to receive the majority of payment upfront, with the earn-out used primarily to bridge the gap, as discussed, between expectations should the buyer require some extra reassurance of the seller's claims regarding the firm's value.

In the case study below, Instem plc, an IT solutions provider, agreed to pay £1 million upfront for its acquisition of Perceptive Instruments Limited, with a £300,000 earn-out payment, which was agreed in conjunction to specific financial targets, all of which were met by the business.

The targets or benchmarks used in any earn-out are in many respects the most crucial aspect of the agreement. This is also where an M&A adviser or legal expert will really prove their worth in negotiations. The key is to agree on targets that suit both seller and buyer and to ensure that they can be easily proven in the future.

Many people assume that a buyer will want to set targets as high as possible, but the risk this poses to staff moral and performance can result in such aims achieving the opposite of what was intended. Equally, a seller can't opt for ludicrously low targets or a buyer has no incentive to pursue the purchase. So a middle ground must be found that shows a realistic vision of the future as well as consistency with historical operations.

Basing targets on EBITDA is often a popular option that works for both parties, though somewhat cumbersome to structure and reach agreement on. Simpler earn-out deals are often commonly based on revenue, cash flow or even the generation of new business and routes to expansion. Whichever metrics are eventually chosen, be sure that they are clearly defined in the legal documents to reduce room for costly disagreements down the line.


Instem's earn-out purchase of Perceptive

The Facts

Purchase Date: November 2013
Earn-out Period: 1 year
Upfront Payment: £1 million
Performance-based Earn-out: £300,000
Total Maximum Consideration: £1.3 million

IT solutions provider Instem plc, a business with a focus on the global early development healthcare market, bought Perceptive Instruments Ltd in November 2013.

The purchase was driven by Instem's desire to expand into the in vitro R&D marketplace, an aim that sat well with Perceptive's position as a developer, manufacturer and supplier of software and hardware products for “in vitro study data collection and study management in the genetic toxicology, microbiology and immunology markets”.

Perceptive's position as a market leader in a very niche arena made it an ideal target for Instem. By allowing for the earn-out clause in the Acquisition Agreement, both parties ensured that the acquisition was a success, both in terms of financial returns and business development.

Philip Reason, chief executive of Instem, commented: “The acquisition of Perceptive has been a success, not only in terms of the financial contribution the acquisition has made to date, but also in terms of expanding the Company's offering into the in vitro data collection and study management in the genetic toxicology, microbiology and immunology markets. We are looking forward to another strong contribution from this arena in 2015 and beyond.”


Ultimately, with the right benchmarks in place and a well drawn-up contract, earn-outs offer an excellent solution for both parties to get what they want.

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