Complete Business Counsel For Privately Held Companies

What is an Earn-out?

In connection with the purchase and sale of a business, including a merger transaction or sale of substantially all of a business’ assets (a merger and acquisition or “M & A” transaction) an earn-out is a mechanism to delay and make contingent payment of a portion of the purchase price. It is a drafting device used to bridge the gap between what a seller (target company) believes it should receive and what the buyer is willing to pay. The earn-out portion of the purchase price is calculated and becomes payable with reference to the target company or business’ performance over a designated period of time after the closing of the M&A transaction.

Typically, an earn-out is structured as one or more contingent payments that become payable if the target company achieves post-closing specified metrics. Those metrics could be a designated threshold minimum gross revenue, minimum earnings before the deduction of interest, taxes, depreciation and amortization(EBITDA), or achievement of certain development metrics within the period or periods specified. If the target company fails to achieve these targets within the set periods, the buyer does not pay the contingent payments, or, depending on what was negotiated, pays only a fraction of the earn-out amount.

Structuring an Earn-out

Earn-outs are tailored to fit the target company's business and the buyer and target’s expectations. In each circumstance, however, certain common items are addressed:

  • The amount or range of the earn-out(s) payments;
  • The earn-out period(s) and metrics that must be achieved for payments to be “earned”;
  • Whether the right to an earn-out is subject to buyout or acceleration of payments.

Earn-out Metrics

Parties use either financial and/or non-financial metrics as targets triggering the right to an earn-out. In some cases, combinations of the two are used successively, for instance, non-financial targets during the first year of the earn-out period and financial targets thereafter. Most earn-outs include some form of financial targets, such as:

  • Gross Revenue;
  • Net income;
  • EBITDA;
  • Earnings per share.

If anything other than the acquired business’ gross revenue is the metric, structuring financial metrics can involve delicate negotiations. There can be concern by the target that it will not have control sufficient to realize the earn-out. The buyer, on the other hand, does not want to create incentives for the acquired business to sell services or product without regard to gross margins. One sometimes sees top line gross revenue as target metrics, with adjustments upwards or downwards depending on average gross margins realized. Whatever the parties decide, it is critical that the transaction documents clearly express the accounting principles to be used in measuring the target company’s performance.

Earn-out Durations and Payments

Most earn-outs last between one and three years, but there are earn-outs with shorter or longer periods, and there can be a series of tiered earn-outs.

For earn-outs with short periods (one year or less), there is usually just one payment at the end. Earn-outs with multi-year periods typically have multiple earn-out payments payable at certain intervals.

The amount of the earn-out payments can be:

  • A flat amount. If there are multiple payments, the amount can be increased, decreased or kept constant during the earn-out period depending on performance.
  • A multiple of the amount by which the target company's performance exceeds the earn-out target metric.
  • A percentage of the earn-out target specified: for example, a percentage of the gross revenue above a floor.

Buyout or Acceleration of Earn-out

The parties should address whether a given earn-out should include a buyout option for the buyer or acceleration rights for the target. A buyout option permits the buyer to pay a specified amount to satisfy any remaining earn-out payment obligations. This can be useful if the buyer might want to sell the target company before the expiration of the earn-out period by allowing the buyer to avoid having to work around any covenants or target rights that might impede resale of the target company. An acceleration provision requires all of earn-out payments to become immediately due upon the occurrence of certain events. Those can include:

  • Sale of the target company or a substantial portion of its assets;
  • Breach of operational covenants by the buyer;
  • Termination of certain key employees of the target company – which termination could, in the eyes of the target, jeopardize its ability to achieve earn-out metrics.

An acceleration provision helps protects the target from changes that adversely affect the target company's ability to achieve the earn-out targets.

Authored by Andrew (Drew) Piunti, drew@dpalawyers.com, ©2015

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