What are the main advantages and disadvantages of earn-outs?

When businesses and their assets are sold, buyers will need to structure and finance the purchase price. Occasionally the full price will be paid on completion; however, commonly the buyer either cannot afford to pay it all at that point, wishing to make a defined deferred payment, or may consider it to be too risky.

An “Earn Out” is an arrangement by which the price that the buyer pays is based on its performance after the completion of the acquisition. Often there will be a payment upon completion, perhaps reflecting the value of the net assets of the business. This can then be followed by one or more further payments based on the performance of the business over subsequent reference periods based on turnover or gross profits for example.

Earn outs are most useful when it is difficult to value a business or for new businesses whose track record of profitability has not yet been fully established.

For the buyer earn outs have the advantage that if the performance of the business fails to reach the target set then its obligation to make further payments to the seller will be reduced or even eliminated. Accordingly an earn out allows the buyer to hedge its risk on an acquisition which can be a vital part of the financing.

For the seller, an earn out increases the risk in a transaction because often the main part of the purchase price is deferred until after accounts have been drawn up to assess the performance. This could be a year or two after the business has been sold. Furthermore the seller may not receive security for the deferred payments and will have relinquished much of its control.

A contract for an earn out will include provisions relating to the preparation of accounts to assess the financial performance of the business and therefore determine the price payable, provisions for settling any dispute relating to those accounts, and protection for the seller to deal with how the business will be managed after completion, imposing constraints on the buyer on how the business is run. It is here that the seller should be worded correctly.

The Seller may be able to negotiate a more lucrative deal with an earn out, so that both buyer and seller can benefit from good performance during the reference period. By sharing the risk on future performance, the potential upside may be greater than the buyer would be prepared to pay on a fixed price deal. How the deal is structured ultimately comes down to the relative bargaining position of the buyer and the seller.

In conclusion, while an earn out may have attractions to a buyer, it can be less attractive to a seller. Both parties risk disputes arising about the amount payable under the earn out which may be costly and time consuming to resolve. By wording the acquisition agreement correctly, both parties face a more certain outcome.