Earnouts - key issues to consider

When buying or selling a business, there is frequently a gap between the seller's perception of the business's potential worth and the price a purchaser is prepared to pay based on actual performance. One way of addressing this is to include an earn-out as part of the deal. In this situation, the purchaser will typically pay 60-80% of the asking price upfront, with the remaining 20-40% to be paid subject to the company achieving performance targets agreed by both parties within a designated period.

This type of deal works particularly well for businesses where there is a high degree of uncertainty about the future. These include high growth/new companies, companies with unproven new technologies or artistic/creative assets. It is also a good option when a company is overly dependent on the owner or other human assets, as in the case of many recruitment or other service businesses, since the seller is then financially committed to ensuring that goodwill and key staff remain with the business.

When is an earn-out appropriate?
Firstly, in order for an earn-out to be successful, all the owners of the business must have a desire to stay on and assume a significant amount of responsibility for the running of it. Any business where there are sleeping partners (for example, part-ownership by private equity) is unlikely to be suitable, as there will undoubtedly be conflict between those who want to receive as much as possible upon completion and those who want to maximise the earn-out. The buyer should also be prepared to keep the acquired company's operations separate from any existing businesses, as otherwise it will be difficult to gauge its performance in relation to the targets set. Therefore, any sale where the business is to be quickly integrated into the buyer's existing business is generally not suitable for an earn-out.

Structuring the deal
Perhaps the most difficult element of an earn-out transaction is deciding how the business is to be run post-acquisition. The agreement must be a compromise between the seller, who wants to remain at the helm of the business so as to maximise profits and ensure that the targets relating to the earn-out payments are met, and the buyer, who will want the freedom to act in the interests of the whole company when making key decisions (such as pursue new business opportunities), without interference from the seller.

When negotiating the deal, the seller should seek to keep as much control as possible over the assets and the budget, the hiring and training of staff and any marketing and sales strategies. It is worth considering including a clause in the contract penalising the buyer if the agreed rules are not adhered to, as well as an acceleration or modification of the earn-out payment if the circumstances of the buyer's business change (such as a sale of the business or any assets within it). It may also be possible to guarantee a minimum payment for the earn-out.

Setting the right targets
While it is easy to assume that it is in the buyer's interests to set the threshold as high as possible for deferred payments, unrealistic targets can destroy staff morale within the business and impact upon performance. As well as setting achievable targets, both buyer and seller need to offer incentives to key members of staff. The buyer can do this through stock options or performance bonuses, while the seller should consider allocating a portion of the earn-out to reward high-performing staff.

It is also important to establish exactly how performance is to be measured within the terms of agreement. This should include the way in which the accounts will be drawn up, the treatment of any management or central charges, the cost of funding and the availability of resources for business opportunities, etc. Basing payments on gross rather than net revenues can simplify the process considerably, and avoid potential disputes over the way profits are calculated, however if you are the buyer it may be better to use net earnings, which have more flexibility and better reflect the business's true performance. You may also consider using other methods to determine performance, such as cash-flow or even the generation of new business.

Timing
Setting the timescale for the payments is a key factor in determining the success of the deal. This needs to be long enough for the buyer to ensure that the seller will invest in the business's future rather than focus on purely short term gain, while from the seller's point of view the risk of reaching the agreed targets increases the further away those targets are. As a general guide, it is best to structure the earn-out over two or three years, with interim payments. Also agree on the method of payment for any settlements, if you opt for cash, this is likely to have tax implications.

Finally, it is worth being aware of other options that can provide useful alternatives to an earn-out if the seller wishes to remain with the business. These include taking shares in the acquirer as part of the deal, converting the earn-out into a royalty agreement, or simply remaining with the business as an employee, receiving a salary and bonus payments.

Conclusion
When structured properly and applied in the appropriate circumstances, an earn-out can be a win-win situation for both buyer and seller. The seller will be financially rewarded for the anticipated future value of the business, while the buyer avoids overpaying for untested potential and ensures that the seller remains motivated during the handover period. If the targets for the earn-out are met, the seller receives an excellent price for his business (the sum paid out from the deferred part of the deal can in some cases be more than the initial amount received at completion), while the buyer is happy to pay the consideration, as he is now the owner of a highly profitable and valuable business. However, the flip side of this is that earn-outs are complex transactions that carry a significant unknown element for both parties, and there are many pitfalls that can lead to disaster if the terms of the deal are poorly set out.

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