What is an earn-out?
An earn-out is a general expression covering any mechanism where, on the sale and purchase of a company’s shares or its business and assets, the purchase price is wholly or (more usually) partially determined by reference to the future performance of the target company or business.
The classic earn-out is calculated by reference to profits over, for example, the two or three financial periods after completion. It is also possible, but less usual, to link the earn-out to turnover, net assets or any other financial measure which is appropriate to the transaction in question.
Earn-outs tend to be most frequently used in relation to acquisitions in the service sector. In these circumstances, the assets being acquired may be worth only a small fraction of the purchase price and future performance can often be the key to justifying the consideration. They are also extremely common where the target company has a short track record but significant growth potential.
An earn-out has advantages for both sellers and buyers.
a) It may provide a mechanism whereby the sellers can reap the full benefit of selling a profitable business. Without an earn-out, the price the buyer is prepared to pay may be discounted as a result of doubt about the actual profitability of the target.
b) It may give the sellers an opportunity to benefit from the advantages of being part of a larger buyer’s group. However, it can also give rise to a number of difficult issues in the process.
a) It ensures that part of the purchase price is directly linked to the actual performance of the target business after completion. This can remove a significant element of uncertainty from the transaction.
b) Part of the purchase price will be deferred for a period after completion, which will be beneficial from a cash flow perspective.
c) In a scenario where all or some of the sellers are key to the target business, the existence of an earn-out can incentivise such sellers and assist in retaining their loyalty.
Disadvantages of an earn-out
1. It can be desirable to have a “clean break” on completion of the sale and purchase of a company. An earn-out means that the sellers will retain a very significant interest and, in most cases, a day-to-day involvement in the target business going forward.
2. At the most general level, both buyers and sellers have an interest in maximising profits after completion. However, a significant number of issues are likely to arise in the negotiation of the earn-out which can give rise to conflict between the two sides.
3. Fluctuations in profitability in the post-completion period can make it extremely difficult to exclude such fluctuations from the earn-out calculation. This may work to the advantage or disadvantage of either party, depending on the circumstances.
4. Earn-outs can (and very often do) give rise to particularly tricky and complex taxation questions, which require specialist input and a good working knowledge of the tax issues that can be faced.
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