Earn-outs are a common feature of M&A transactions and when used properly, can provide the parties with an additional opportunity post-deal to true-up and validate the headline price.
When not given appropriate focus and attention, or poorly-drafted in the SPA, earn-outs can damage the business and can create significant contentious post-deal disputes. Indeed, our 2017 survey respondents reported that earn-out clauses were one of the most disputed areas of SPAs post-deal. In this report we seek to set out the core principles of earn-outs and the pitfalls to avoid, to make an earn-out successful.
Earn-outs are particularly useful when:
- the buyer is acquiring a business in a new market or industry where future performance is less predictable
- the target business is expected to experience significant growth in the near future and the seller wishes this to be factored into the price
- it is beneficial to retain the expertise of and to incentivise existing management to ensure the future success of the business
- bridging a value perception gap between the parties, resulting from different expectations of future performance.
How to avoid disputes
Given that future performance is unknown at signing, and it is subject to a myriad of factors with varying degrees of control and predictability by the parties, it is unrealistic to mitigate all risk of disputes arising from an earn-out. However, a great many could be avoided by ensuring as far as possible that the earn-out provisions in the SPA are clear and unambiguous.
Clarity can be improved by having:
- clear definitions for what should be included/excluded, preferably illustrated by way of a pro-forma earn-out schedule calculation
- clear accounting policies dealing with judgemental areas open to interpretation and manipulation
- a clear reference point for measuring earn-out results consistently with prior results and the target, eg by reference to an historical set of audited accounts or diligence management accounts.
Buyers/sellers of a business should consider these key points before the SPA is agreed:
- Earn-outs are becoming an increasingly prominent component of transactions, for sound commercial and operational reasons
- The length of the earn-out and principles to be applied in each deal is of vital importance to both buyer and seller
- The need to have clear, unambiguous drafting in an SPA in respect of the earn-out is vital and is fundamental to a successful deal
- Earn-outs can be used in combination with either locked box or completion account mechanisms
- The appetite for an earn-out will be strengthened by the nature and purpose of the deal and the nature of the parties to the transaction
- In the event of an earn-out dispute, it is important that a suitable dispute resolution process has been indicated in the SPA, typically involving expert determination by an independent accountant
Download Earn-outs: How to avoid pitfalls and protect value to find out more.