Earn-out when pur­chas­ing a company: guar­an­teed success or cause for conflict?

Buyers and sellers do not always agree on the price when selling a company. This is often due to having different per­spect­ives on the target. While the buyer explores all the risks, the seller wants to win big with the business’ potential. Sometimes the price ex­pect­a­tions can be very far apart. The earn-out clause is a part of the sales contract that can satisfy both parties. But the clause should be treated with caution. It does simplify some processes, but it also comes with a wide variety of risks. What exactly is an earn-out and for whom is the clause in the contract worth­while?

An earn-out is a clause in the sales contract that stip­u­lates that the buyer will receive a flexible purchase price in addition to a basic amount if the target company achieves a certain per­form­ance target after the company has been sold. This way, the seller always receives the agreed basic price. The sub­sequent bonus and the con­di­tions attached to it are worked out by the buyer and seller at their own dis­cre­tion. And this is where the crux lies. In­ex­per­i­enced or reckless ne­go­ti­at­ing partners may set goals or con­di­tions that can cause con­sid­er­able in­con­veni­ence to one or both parties. Ma­nip­u­la­tion attempts, high tax payments, or lost profits are some of the potential con­sequences.

It is always advisable to have a sales contract checked by experts on both sides. In par­tic­u­lar, the ob­lig­a­tion arising from the earn-out clause after the handover date requires detailed ex­am­in­a­tion – even after the purchase has been concluded.

The CEO of the tech­no­logy start-up Pinkyswear, and the large tech­no­logy cor­por­a­tion, High­fly­ingTech, meet. Pinkyswear has developed an in­nov­at­ive product, but cannot afford a patent for it and therefore can’t begin to make a profit. However, they expect high sales as soon as the product is on the market. They want to sell the company for £15 million.

High­fly­ingTech is in­ter­ested in the product, but realises there will be a long test phases before the product can be launched on the market under their name. They are skeptical about the start-up’s high sales forecasts. They don't want to pay more than £7 million for Pinkyswear. However, they generally see potential in the product. So the two managing directors agree on an earn-out clause.

To make this work, you choose an ob­ject­ively veri­fi­able measure: the sales revenue. If the turnover in the year after the purchase reaches £15 million, High­fly­ingTech will pay an extra £8 million to the former operators of Pinkyswear in addition to the original purchase price of £7 million. If the target company achieves a turnover of at least £7 million, High­fly­ingTech will pay a pro­por­tion­ate share of £3 million. If the company generates fewer or no sales, High­fly­ingTech retains all payments above the base price.

In order to check the sales volume, the sellers of Pinkyswear know they have the right to inspect High­fly­ingTech’s annual accounts and any other documents. They pay par­tic­u­lar attention to whether any profits have been postponed to the next year or in­vest­ments have been made, because this kind of ac­count­ing can easily affect the results. That's why it’s important to specify in the clause how the ac­count­ing should be handled.

There are various ways to implement an earn-out if you want to do so. The payout can be linked to the total turnover of the target company. More accurate pre­dic­tions and results can be obtained from the sales of a product or with an existing customer. There are financial and non-financial meas­ure­ments and they can be a fixed value or within a target range. What is important, however, is that it is a precisely veri­fi­able variable. Many also use EBIT or EBITDA as a basis.

The time at which this target is reached is called the trigger event. The con­tract­ing parties determine whether the trigger event describes a single, fixed objective, or has several in­ter­me­di­ate ob­ject­ives. In practice, par­ti­cipants use either cu­mu­lat­ive trigger events or pro­gress­ive trigger events. In the case of cu­mu­lat­ive trigger events, the total of the reference values ac­cu­mu­lated over a certain period (for example, EBIT) must reach or exceed the reference value. With pro­gress­ive trigger events, the buyer only receives an earn-out if the meas­ure­ment increases each year. 

The earn-out period (also known as the base period) is the time between con­clud­ing the contract and the day on which the specified meas­ure­ment must be reached.

Two important variables in the earn-out clause are floor and cap. A seller will try to achieve the highest possible amount with the floor. Since this is the minimum amount of the payout, it is linked to a minimum target. If the company does not reach the minimum target, the seller does not receive any ad­di­tion­al money. The cap is the upper limit of the earn-out. This keeps the buyer's spending within limits.

In certain cir­cum­stances the company fulfils more than the set ob­ject­ives. In cases like this, an addition in the clause regulates how the buyer re­mu­ner­ates the seller. The so-called ad­just­ment is a per­cent­age value that increases the sum of the target earn-out depending on the amount of over­ful­fill­ment. There are three cal­cu­la­tion methods:

• Linear: One percent over­ful­fill­ment results in a one percent ad­just­ment of the earnout
• De­gress­ive: The higher the over­ful­fill­ment, the lower the per­cent­age ad­just­ment
• Pro­gress­ive: The ad­just­ment increases ex­po­nen­tially with over­ful­fill­ment (also called ac­cel­er­at­or)

Pro­gress­ive ad­apt­a­tion can dis­ad­vant­age the buyer. In pro­fes­sion­al circles, it is often called stran­gu­lat­ing. This is because the ad­just­ment may grow so quickly that the buyer is left with a minus after paying the earn-out. This is why it is important to have a cap.

The earn-out model is suitable for balancing deviating purchase price ex­pect­a­tions of a target object. This works es­pe­cially well if the two parties estimate the company’s future profit per­form­ance dif­fer­ently. By not agreeing on a price, this only postpones ne­go­ti­ations into the near future. An attitude like this is the basis for ma­nip­u­la­tion attempts. This results in conflicts between the parties, leading to po­ten­tially dis­pro­por­tion­ately expensive legal disputes. If, however, the buyer and seller enter the ne­go­ti­ations with a positive outlook and want to promote the target company, the earn-out clause opens up a variety of op­por­tun­it­ies that are prof­it­able for both sides.

An earn-out is es­pe­cially worth­while for people who want to sell their start-up. The young company has usually invested a lot in its products or services. Even if the turnover is good, the profit remains modest for the time being. Selling to a larger company increases the company’s chance of becoming more suc­cess­ful. The start-up founders do not have to let the expected profits be taken away. At the same time, the buyer is protected because they only pays more if the business makes a profit or ex­per­i­ences other positive de­vel­op­ments.

A generic template shouldn’t be used for the earn-out clause; you should take into account the in­di­vidu­al char­ac­ter­ist­ics of the target company as well as the market situation. Some areas of ap­plic­a­tion benefit par­tic­u­larly from this clause:

• In eco­nom­ic­ally uncertain times, the clause enables a sale to be made at a fa­vour­able price, but op­tion­ally offers a fair com­pens­a­tion in the future.
• Eco­nom­ic­ally badly po­si­tioned companies that tried to save them­selves by re­struc­tur­ing, po­ten­tially receive a surge from the sale, the profits of which are reflected in the earnout.
• Companies that are dependent on a specific product or specific customers have a par­tic­u­lar sens­it­iv­ity to the subject. The expertise of the employees and managers creates added value for both sides after the takeover.
• Companies that develop com­pletely new products or tech­no­lo­gies have a lot of future potential. But since there is also a risk that in­nov­a­tion will not be able to hold its own, the earnout builds a bridge between in­vent­ive­ness and risk con­tain­ment.

The earn-out model brings the two parties of a company purchase closer to a selling price that is fair and com­pre­hens­ible for both parties. Dr. Frank Koch of the in­ter­na­tion­al law firm Taylor Wessing notes, however, that the later payout can have an opposite effect. He cites psy­cho­lo­gic­al reasons being the cause: once the buyer has paid the basic price, the company becomes their property. They will act at their own dis­cre­tion to make sure there isn’t any un­ne­ces­sary ex­pendit­ure. Con­sequently, the earn-out payment should be kept as low as possible in order to avoid losses. This can lead to the results being ma­nip­u­lated.

According to the economic expert, some buyers were accused of de­lib­er­ately gen­er­at­ing higher costs in order to keep the profit margin low. Others are said to have been accused of post­pon­ing the product marketing of the re­spect­ive driving force of a target company beyond the earn-out period. Another classic tactic: tasks that should go to the target company are shifted to a sub­si­di­ary.

Pre­vent­ive measures: In the earn-out clause it should state which standard the ac­count­ing will follow under the new man­age­ment, for example, the In­ter­na­tion­al Financial Reporting Standards. An example cal­cu­la­tion in the clause itself cements the con­fid­ence of both parties when it comes to the cal­cu­la­tion methods. Therefore the parties involved can exclude certain meas­ure­ments from the cal­cu­la­tion – expenses such as interest on the purchase price financing or those arising from payouts.

If the buyer decides to provide the seller with insight into the contract, order dis­tri­bu­tion, and marketing strategies, the seller at least has the op­por­tun­ity to provide evidence in the event of a legal dispute. At the same time, the buyer should arrange their company man­age­ment for the earn-out period in such a way that it allows a fair as­sess­ment of the reference value.

But even the seller can be tricked. If the former boss of the target company remains in the company as an employee, the person may influence the business in such a way that profits are dis­pro­por­tion­ately included in the annual balance sheet. On the other hand, the interest in the earn-out payment can serve as an incentive for the seller and inspire their work under the new man­age­ment. Before expensive legal disputes arise, both sides should pree­mpt­ively protect them­selves with a well-tested earn-out.

The tax risks of a company ac­quis­i­tion contract with an earn-out clause often affect the seller. Therefore, the seller will no doubt want to have the clause examined for tax purposes. Under certain cir­cum­stances, the details of the agreement mean that the total proceeds from the sale, including the expected earn-out, must be fully taxed im­me­di­ately after the contract has been signed.

However, an earn-out is both an amount that will only be paid out in the future and a flexible amount that is po­ten­tially not paid out at all – or not fully. If taxes become due im­me­di­ately and in full, the seller may not have the financial means to pay. Es­pe­cially since further li­ab­il­it­ies arise in sales situ­ations.

Another stumbling block is em­ploy­ment after the sale. The trend in start-up purchases, for example, is for buyers to acquire the company in order to protect the qualified employees who con­trib­uted to its success in the first place. For start-up managers, the earn-out model can be a short-term incentive. If they fit into the new corporate structure and con­trib­ute their know-how and contacts, the new owner's profit will also bring them a bonus in the form of an earn-out. However, as an employee, you will be paid wages and will have to pay income tax and social security con­tri­bu­tions. If they receive their earn-out payment in the same way, their tax rate will skyrocket. When paying out, the buyer should make sure that it is not counted as a wage payment.

In the case of several trigger events happening, the base period sometimes extends over several years. The trend has a tendency towards an earn-out period of one to two years, but three years or more is not uncommon. If the target company fulfils all set trigger events within this period, the seller is con­sequently entitled to their earn-out payment. Sometimes it might be that only the new target company is making profits, but other projects are making losses. If the new owner then has to settle li­ab­il­it­ies from the profits of the target company, there aren’t any liquid items to pay the earn-out.

Pre­vent­ive measures: Since there is a right to the liability, but it is only paid out after a certain time and as needed, changes in con­di­tions may make payment more difficult. As long as no pro­gress­ive ad­just­ment has been agreed upon, the capped amount will not change. If the buyer deposits the maximum earn-out amount with a trustee, this fixed amount remains protected. In the event of a trigger event, the amount can be paid out in full or in part. For this you use a reverse escrow.

If the growth forecasts for a company’s de­vel­op­ment after its purchase diverge con­sid­er­ably between buyer and seller, a well-planned earn-out clause enables the parties to make the re­mu­ner­a­tion fair and realistic for them­selves. If companies are up for purchase, but are de­vel­op­ing in an uncertain but po­ten­tially positive way, adding a contract is a good idea. Since the start-up scene in the UK continues to evolve, this type of per­form­ance-based com­pens­a­tion is likely to be seen more fre­quently in the future. Before you decide on this com­mit­ment, re­capit­u­late the ad­vant­ages and dis­ad­vant­ages of the earn-out clause.

Please note the legal dis­claim­er relating to this article.