The valuation of a company is the cornerstone of any M&A transaction. Naturally, sellers want to achieve the highest possible price, while buyers do not want to overpay. However, the dynamics of transaction processes and their complexity may lead to changes in the parties’ expectations as to the price agreed in the early stages of negotiations. Similarly, the financial overview of the company being sold often varies significantly at different stages of the transaction process and noticeably so immediately after closing. It is therefore useful to be familiar with the methods and tools that can be used to manage the purchase price of a company. One such tool is the earn-out mechanism.
Earn-out: how to align the expectations of both parties
The earn-out is a commonly used mechanism among the many ways to adjust the price in the event that more time elapses than anticipated between the signing of the contract and the closing of the transaction.
The earn-out mechanism provides the seller with the opportunity to receive a post-closing price premium if the company being sold meets certain parameters or financial goals.
Such parameters may vary and may involve, for example, a certain level of revenue or income, meaning that not only the revenue but also the cost of generating that revenue, may be relevant in determining whether an earn-out is due.
One of the most commonly used measures of a company’s earnings growth in earn-out clauses is EBITDA.
However, the reason for the earn-out payment may also be non-financial, such as the company obtaining a patent within a certain period after the closing of the transaction.
The earn-out mechanism is a solution that reconciles the parties’ conflicting sale price expectations. The seller knows that they should get more for the company being sold because of its high growth potential, which will often be confirmed by post-closing results.
The buyer, on the other hand, is aware that the price expected by the seller will not be paid immediately, and that a certain part of it will be deferred and will depend on the prior achievement of the forecast results.
Earn-out in M&A transactions
For the above reasons, the earn-out mechanism is a commonly used solution in M&A transactions and so is worth a closer look.
At first glance, the issue seems simple, but it can be more complex than it seems.
Securing the earn-out payment depends not only on the efforts made to achieve certain results, but also on the transaction documentation containing a well-drafted earn-out clause.
To illustrate this with a concrete example, consider a transaction in which the seller has been given the option to increase the price in an earn-out formula if the company achieves a certain level of EBITDA within the next six months after the closing of the transaction.
From the seller’s perspective, one of the first questions that will arise is how to ensure sufficient control over the company during this period to have a real impact on the ability to deliver the results on which the earn-out payment depends.
It is easy to imagine a situation where the buyer, as the new owner, is not interested in a price premium and deliberately sets operating costs or other parameters that affect the seller’s expected results, thereby making it difficult for the seller to secure the earn-out payment.
This justifies the need for the seller to be able to impact the cost policy of the divested company, or other relevant parameters, for a period of time relevant to determining whether an earn-out is due.
From the buyer’s perspective, the inclusion of an earn-out clause also requires special attention and consideration of possible consequences. The buyer will be interested in ensuring that the measure of the company’s performance, on which the earn-out payment is based, is clear enough to link the possibility of a price premium to the actual results achieved that are relevant from the buyer’s perspective.
The seller should also expect a clear and objective earn-out formula and have an equal interest in avoiding disputes in this respect.
Earn-out: the art of balancing needs and expectations
The drafting of an earn-out clause is a matter of balancing the expectations of both parties to the transaction. The need for the seller to retain some control over the ability to achieve the results on which the earn-out is based must not unduly interfere with the discretion of the buyer, as the new owner of the company, as to how the company should be operated and managed.
If you would like to know how to draft an appropriate earn-out clause in a contract, how to avoid disputes over its implementation and what other complications may arise, for example, when the buyer sells the company to the subsequent buyer, please do not hesitate to contact me.