Buying or Selling a Business? 4 Reasons Earn-outs Go Wrong (and How to Protect Yourself)
Mergers and acquisitions require a great deal of negotiation, which is why there are many mechanisms by which buyers and sellers can structure a transaction, address specific issues, and ultimately compromise to close the deal.
Earn-out provisions, or earn-outs, are one such mechanism.
What Are Earn-Outs?
“Earn-out provisions in purchase agreements typically arise in situations where there are differing expectations between the buyer and seller as to what the company is actually worth,” says Hendershot Cowart contract law expert Katie Nash.
When it comes to agreeing on a purchase price, buyers and sellers typically have two very different goals:
- if you’re the seller, you generally want the most money possible based on your company’s future prospects and favorable forecasts;
- if you’re the buyer, you want to pay as little as possible in order to mitigate risks that a business won’t live up to its promise.
Earn-out agreements offer a means to bridge this gap, and involve buyers putting up a sizeable portion of the purchase price up front, with the rest to be paid out over a period of years. For example:
A seller wants $100 for their company, but the buyer only wants to pay $80 up front, for any number of reasons, including fears that the business may not perform as forecast. The buyer decides to bridge the gap and agrees that if the company can meet certain goals or thresholds over the next five years, the buyer will pay the seller the additional $20.
When buyers and sellers agree to an earn-out provision in a M&A contract, it means a portion of the purchase price is deferred, and contingent on the company achieving pre-defined financial thresholds or operating “milestones” after the closing over a period of years.
“Earn-out provisions don’t follow any set formula or form,” says Nash. “They are specifically tailored to the transaction at hand and can provide the vehicle for compromise that parties need to close a deal.”
“However,” she warns, “unless they are carefully crafted, earn-outs can and often do result in post-closing disputes.”
Common Problems with Earn-outs
Because there are potential risks associated with earn-out agreements, structuring a carefully crafted agreement that addresses the unique circumstances at hand is crucial. Although every deal is different, there are ways to effectively limit risk associated with earn-outs:
1. Problem: Disputes over metrics, methodology or time periods used for the earn-out formula
Relying on audited financial statements can reduce risks for dispute. However, the new owners of the company may decide to add allocations to the income statement that the seller did not anticipate, changing the bottom line on which an earn-out is dependent.
Solution: Parties should agree on the accounting method and consider excluding the effects of purchase accounting, increased capital expenditures, or other specified items from the earn-out calculation. The parties must agree on valuation and definitions of gross revenue, sales revenue, net profit, or earnings before interest, taxes, depreciation and amortization (EBITDA).
The buyer and seller should also clearly define the schedule for earn-out payments, understanding that the time between contract negotiation and the closing of the sale may be longer than anticipated and could impact the timeline for achieving the established milestone or financial goal.
2. Problem: Disagreement over Whether Buyer Attempted to Frustrate the Earn-out
Should the business fail to meet its financial thresholds or pre-defined milestones within the negotiated timeframe, the seller may feel that the buyer ran the business in such a way as to purposefully frustrate the earn-out. Did the buyer change the product, pricing or marketing? Did the buyer delay a product launch or fail to meet a regulatory hurdle? All of these variables may lead to disputes if not clearly addressed in the earn-out provision.
Solution: Buyers should disclaim any obligation to ensure or maximize the earn-out payments and include a provision that expressly permits the buyer to operate the business at its discretion post-closing.
Conversely, a seller may seek to include a provision to the effect that the buyer must conduct the business consistent with past practices. The seller should tailor the provision to address specific business practices, such as marketing or pricing plans, budget, or operations. Under such a covenant, the buyer may want to add an option to accelerate earn-out payments to regain full control over their business practices.
3. Problem: Sellers Denied Access to Financial Statements
It happens more often than you think, says Nash. “We have dealt with multiple cases in which a seller came to us for representation because the buyers locked him or her out of the business and became unresponsive to requests for financial statements.”
Solution: Include the right to periodic written financial reports and in-person meetings in the earn-out agreement.
4. Problem: The Earn-out Provision Does Not Address Dispute Resolution
In the event of a dispute, who will settle the matter? If it is an accounting dispute, who will select and pay for the independent accountant to conduct the audit?
Solution: In addition to avoiding disputes through clear and specific language as outlined above, the acquisition agreement should also include a well-defined process for addressing post-closing disputes. Neither party want to find themselves embroiled in expensive litigation. Establish a detailed process and timeline for dispute resolution proceedings, such as arbitration or the use of an independent accountant, and agree that the outcome of the proceedings will be final and binding.
Discuss Your M&A with Proven Texas Lawyers
A poorly drafted earn-out provision can easily turn sour, and be a source of conflict and worry for both the buyer and seller years after an acquisition. Parties should be hyper-vigilant when structuring an earn-out provision so that their interests are advanced, and risks minimized while striking an important compromise.
At Hendershot Cowart, P.C., our Houston-based attorneys have extensive experience counseling small- to mid-size business owners, executives, and investors across a range of industries in matters related to earn-out agreements, mergers and acquisitions, and other business transactions. To speak with a lawyer about your matter, please call or contact us online.