When negotiating the purchase and sale of a business, the parties to the transaction frequently look for ways to structure the deal to ensure that all parties’ interests are met. Buyers are primarily concerned with ensuring that the price paid for the business aligns with their expectations for the future growth and revenue generation of the business. Conversely, sellers are concerned with ensuring that they receive maximum value for the business that they are selling. A creative way to bridge the gap between their respective views regarding the value and/or future outlook for the business is to incorporate an earn-out clause into the purchase and sale agreement.
An earn-out provision specifies that a portion of the purchase price for the business will be paid to the seller only if the business meets certain predetermined performance or operational milestones over a specified period of time after closing of the transaction. While milestones are frequently based on financial benchmarks including, but not limited to, revenue, net income, or earnings before interest, taxes, depreciation and amortization (EBITDA), they need not be. Indeed, there may be industry specific or other unique measurements that are important to the parties such as the receipt of a governmental approval for a product or obtaining a certain achievement in research and development. Regardless of the target(s) chosen, if the business achieves or exceeds the milestones within the pre-determined earn-out period, the earn-out payment is payable to the seller.
Earn-outs have associated advantages and risks for both sellers and buyers. For example, a seller may be in favour of an earn-out because they typically provide the seller an opportunity to realize a greater amount from the sale of the business. Conversely, an earn-out can be a risky proposition for a seller if they have limited control over the operations of the business during the earn-out period or restricted access to the records of the business post-closing. There may also be a concern that the buyer can manipulate the earn-out calculations to the detriment of the seller.
Buyers may be in favour of an earn-out because it can align the risk of achieving an overly-confident seller’s forecasts with the value ultimately received by the seller. It also reduces the amount of consideration due from the buyer at closing and potentially provides assurance that the buyer has received the bargained for value of the business. The buyer also assumes some risk in agreeing to an earn-out, including, if the seller continues to work in the business, the potential for the seller to sacrifice the long-term interest of the business for short-term maximization of his or her earn-out payment.
An earn-out provision can be a useful tool to bridge the valuation gap between a buyer and seller. That said, negotiating and drafting earn-out provisions can be challenging because of the numerous variables and an earn-out’s vulnerability to manipulation by the parties. The calculation and payout of earn-outs can also result in post-acquisition disputes. As with many provisions in a purchase and sale agreement, earn-out provisions are unique to each transaction and careful attention is required to ensure that the earn-out is structured to meet the needs of the parties and reduce the likelihood of future disputes.
If you are interested in learning more about earn-out provisions, or if you are contemplating the purchase or sale of a business, please contact Keith Inman at [email protected] or by phone at 250-869-1195.
Keith Inman is a securities and M&A lawyer with broad experience in the capital markets. Keith regularly advises individuals and companies with respect to purchases and sales of businesses, capital raises, securities reporting and compliance matters and other corporate/commercial matters. Keith is qualified to practice law in both British Columbia and Alberta. You can reach Keith at 250-869-1195 or by email at [email protected].
