Structuring Earn-Outs in M&A Transactions
In the context of merger and acquisition (M&A) transactions, buyers and sellers are always looking for ways to ensure that they each receive full value. Generally, sellers are asked to make certain representations about the status of the target business from which buyers determine the prospects of the business they are acquiring. An inventive way that the parties to M&A transactions have come up with to try to mitigate the risks the buyer is taking on, including to ensure that the purchased business continues to generate the revenues the buyer is expecting, while at the same time providing the compensation that the seller believes is fair, is through the mechanism of an “earn-out” provision in the purchase and sale agreement.
What is an Earn-Out?
An earn-out is a negotiated payment arrangement over time between a buyer and seller. The seller agrees to receive at least part of the purchase price in the form of one or more contingent payments following closing (i.e., after the date on which the sale is completed and the buyer takes possession of the purchased business). The quantum and timing of the deferred payments are usually determined by reference to certain performance or operational benchmarks of the target company or the combined company over a period of time after closing. In other words, an earn-out is a type of contingent payment payable only upon the attainment of certain pre-defined parameters, such as specified EBITDA or revenue targets.
An earn-out should not be confused with and is not the same as a purchase price adjustment, which is often based on historical parameters as reflected in the target’s financial statements as of the closing date of the transaction. In an earn-out arrangement, the seller generally (but not always) continues to work in the business following closing and therefore has a direct influence on the performance of the business. If it performs as expected, the seller will receive one or more payments at a predetermined time, which payments represent the deferred portion of the sale price of the business.
The amount and timing of the earn-out payment(s) to be received can be as creative as the parties desire (assuming there is agreement on the concept of the deferred payment, to begin with); earn-outs can be based on revenue targets or growth targets, they can be paid periodically or on a one-time basis, they can be as small or large of a percentage of the sale price as the parties might agree. The payments can be made out of cash flows or out of the general resources of the buyer; the amount can be held in escrow or represent a secured or unsecured obligation of the buyer. In addition, the involvement of the seller in the business post-closing can be either significant or fairly transparent to anyone dealing with the business after closing. Consequently, with no set structure, earn-outs, if they are agreed to at all, tend to be heavily negotiated.
A “reverse earn-out” is a variation on the concept. Under this arrangement, instead of receiving an earn-out payment based on a positive multiple or percentage of the performance target, the seller will receive the entire purchase price at closing (whether in the form of cash, promissory note or a combination of both), but will need to return/reimburse a certain amount of money (or reduce/set-off any indebtedness owed by the buyer) if the performance target is not achieved. In other words, the seller in a normal earn-out arrangement will work hard to earn the additional amount, whereas the seller in a reverse earn-out arrangement will strive to avoid paying the amount back.
Purpose and Pros & Cons
In a variety of situations, an earn-out arrangement can help the parties bridge the gap in their respective expectations in order to complete a sale. In a typical earn-out scenario, a seller may be optimistic that its business has great growth potential, while the buyer may not be convinced that the projected results will materialize and may be more reserved about paying in advance an enhanced purchase price which assumes that the target business will achieve those projected results. In these situations, an earn-out feature could be structured to close the deal and to alleviate the concerns of the buyer.
From the buyer’s perspective, an earn-out agreement may be beneficial because:
- it allows the buyer to reduce its initial investment by deferring payment of part of the purchase price and preserve cash or availability under its credit facilities;
- it helps the buyer to avoid overpaying;
- it allows the buyer to reduce leverage, which can be helpful in a tight credit market where the cost of capital is high;
- it motivates the seller to stay on during the transition and earn-out period to ensure performance targets are met; and
- it allows the buyer to potentially offer a higher bid in an auction process because it does not have to pay the full price at closing.
From the seller’s perspective, an earn-out agreement may be beneficial because:
- the seller may be able to receive a higher offer from the buyer;
- it may enable the seller to allocate the incremental purchase price among those shareholders who remain involved in the business following closing; and
- the seller may benefit from a synergy created by the transaction, which may give the seller an upside on the earn-out payments.
However, an earn-out agreement can also have disadvantages. It can be difficult to negotiate and requires careful consideration as to the future conduct of the business and extensive accounting analysis, which can lead to additional cost. It also requires monitoring and periodic evaluation of the target’s performance after closing. Further, even when the target business does meet the performance target, disputes may arise as to how the earn-out payments should be calculated. Moreover, the seller may not wish to remain involved in the business, either due to disinterest or because the seller has commitments to a different venture. An earn-out can also pose risks to the seller. In situations where the seller does not remain involved in the target business following closing, it becomes vulnerable to the actions of the buyer. In the worst-case scenario, where the target does not meet the performance target, the seller would not receive any payments on account of the earn-out.
The earn-out provisions in a purchase and sale agreement must be tailored to the needs and expectations of the parties. It is not a one-size-fits-all solution, and certainly not a magic bullet to conclude an agreement. Careful analysis and negotiations are required to structure an earn-out agreement that will suit the business needs of the parties. Several issues should be addressed in an earn-out agreement, including the following:
- Appropriate performance criteria or targets – These can be either financial metrics (i.e., net revenues, gross margin, net operating income, EBITDA, EBIT or EBT) or operational or project-based (e.g. the completion of a research project, implementing a production line or facility online, or closing of a specific sale).
- Duration of the earn-out period – Earn-out periods typically last between one to three years, although they can be for whatever period the parties mutually agree.
- Payment structure – Payments usually become due and payable at the end of the earn-out period, or at intervals during the earn-out period, when the performance targets have been satisfied or partially satisfied. The amount of the earn-out payments can take several forms, such as a flat amount, a percentage of the earn-out target, a multiple of the amount exceeding the performance target, or any other pre-defined formula. The earn-out payments can be made either in cash or stock. However, when the payments are made using the buyer’s shares, they may trigger additional valuation requirements and securities laws considerations.
- Method of evaluation – To avoid disputes in determining whether performance targets have been met, earn-out provisions should include detailed procedures governing how to measure the performance. For instance, the parties may consider setting out the specific accounting principles and adjustments that are to be applied in preparing the financial statements and provide the seller with sufficient time to review them.
- Impact of extraordinary events – What happens if (in particular, should payment of any remaining earn-out amounts be accelerated), for example:
- the buyer terminates the employment of the seller (assuming he or she stayed on with the business post-closing and agreed to an earn-out in part because he or she would have significant input on the direction and day-to-day operations of the business during the earn-out period);
- the buyer sells the business during the earn-out period (the seller may have agreed to the earn-out on the basis that he or she had confidence in the buyer’s ability to run the business –but not necessarily a third party who is unknown to the seller); or
- the buyer wants to merge the business with some other business, in which case the “earn-out metrics” may no longer be independently measurable.
- Future conduct of the business – The parties should consider whether there is any obligation on the buyer to operate the business post-closing in a manner that is intended to maximize the earn-out or if the buyer is free to run the business as it sees fit. Alternatively, the earn-out could be set up such that the buyer cannot take certain actions that might make sense for the business in the long term but adversely impact the earn-out in the short term (e.g., incurring additional capital expenditures or discontinuing a key product line). In any event, this is a key issue when negotiating an earn-out that can be a source of significant tension between the parties, so it should be addressed early on in the structuring discussions.
- Security (if any) for the earn-out payment – Whether the buyer should be required to pledge the shares or assets of the business to the seller or post some other form of security in the event that the buyer fails to satisfy the earn-out payment.
- Seller’s involvement in the business post-closing – Quite apart from any other considerations, the buyer might need the seller’s expertise, connections or reputation in order to operate the business in the normal course following closing.
- Dispute resolution mechanism – For example, the involvement of an independent accountant if there is disagreement regarding whether the earn-out metrics have been achieved.
From a tax perspective, in the context of a share sale, the earn-out payments will effectively be treated on capital account (in the year that such amounts become determinable) provided that such earn-out payments meet the criteria to apply the “cost recovery method” as enumerated by the Canada Revenue Agency. In general, this criterion only applies in the context of a share (and not an asset) sale and requires, amongst other things, that the earn-out arrangement arises due to difficulties in valuing the underlying goodwill of the business (and not for other reasons). As such, many share sales (and all asset sales) will not meet such criteria, in which case, there is a risk that such earn-out payments will be treated as regular income.
In circumstances where the cost recovery method is not available, a vendor may wish to consider a reverse earn-out. Under a reverse earn-out, the purchase price is set at the maximum possible amount and, provided certain criteria are satisfied, the vendor will generally treat the entire amount on capital account in the year of sale (subject to the availability of a reserve). Moreover, if in a subsequent year the relevant performance criteria are not satisfied (such that a portion of the purchase price must be repaid), the vendor will generally adjust its applicable proceeds of disposition and/or claim a capital loss (and offset such capital loss against its proceeds realized in the earlier year). However, it should be noted that there are a number of complexities involved in structuring a reverse earn-out and whether a reverse earn-out will be beneficial to a particular vendor does depend upon a number of factors including the nature of the assets being sold and the length of the earn-out arrangement.
When structured properly, earn-out agreements can be very useful in bridging the valuation gap between the parties who may otherwise abandon the deal. They could also lead to a win-win situation in that the buyer is protected from the downside risk and the seller potentially can realize a higher price for its business than would otherwise be possible.
However, there are risks posed by such arrangements and potential disputes that can arise. Parties must be diligent in making sure that key issues are addressed in detail in the earn-out provisions of a purchase and sale agreement and that the parties’ needs and expectations are properly reflected in the agreement.
The M&A practitioners at Wildeboer Dellelce LLP have significant experience structuring, negotiating and drafting earn-outs and would be pleased to assist in navigating the various issues associated with them. If you have any questions with respect to the matters discussed above, please contact Al Wiens (email@example.com) or Troy Pocaluyko (firstname.lastname@example.org) or any other member of our Mergers & Acquisitions practice group.
This update is intended as a summary only and should not be regarded or relied upon as advice to any specific client or regarding any specific situation.
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