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?

What is an earn-out?

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.

Definition: earn-out clause

The earn-out clause is a passage in a sales contract that specifies the right of choice to a success-based portion of the purchase price. The target amount, performance indicators, and deadlines are determined jointly by the buyer and the seller. Company acquisitions are when earn-outs are used most frequently.

How the earn-out clause works

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.

The earn-out clause in detail: important terms

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.

Who should consider using an earn-out clause?

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.

Potential risks of an earn-out clause

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.

Manipulation attempts

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.

Tax risks

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.

Liquidity of the buyer

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.

Fact

Escrow is a legal concept in which a financial instrument or an asset is held by a third party on behalf of two other parties that are in the process of completing a transaction.


Overview: advantages and disadvantages of the earn-out

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.

Advantages

Disadvantages

Suitable for future-orientated companies with innovative technology, start-ups and after/during restructuring

Not suitable for postponing disputes during price negotiations

In contrast to the guarantee, where the seller may be reimbursed, the prospect of being able to pay later motivates the sale

The fulfilment of the conditions for the trigger event is influenced by fluctuating business developments

Different price conceptions can be adjusted in a fair way

The seller’s conditional participation rights may lead to power struggles

If the seller remains in the company, the earn-out is a motivation to introduce existing contacts and to work profitably

Implementing the clause extends over a longer period, commits resources (labour, costs)

Both parties benefit from higher yields as long as they motivate the adjustment

Progressive adjustment can curb profit motivation

 

Protection against manipulation can lead to stagnation in the company, and the new management's freedom of action is restricted

 

Incorrect or incomplete wording of the clause can enable manipulation attempts or cause tax disadvantages

Please note the legal disclaimer relating to this article.