M&A fundamentals: Earn-outs in M&A transactions

The SPA should contain clear drafting determining whether the earn-out is payable and, if so, the amount of the payment due. This will typically be tied to financial benchmarks, such as the target’s revenue and/or EBITDA. Sellers will generally prefer revenue-based metrics because they are less affected by costs and there is less scope for manipulation by the buyer. However, buyers often prefer earnings or profit-based metrics, because they motivate the seller to control costs and may be a more reliable indicator of the target’s value. In transactions where the valuation depends on repeatable revenue (e.g. software), a recurring revenue metric may be used. Revenue and profit-based metrics can also be combined (e.g. revenue thresholds with an EBITDA floor). Less often, an operational benchmark may be used (e.g. customer retention, product development or user numbers). It is essential that the SPA is clear as to how achievement of financial metrics is assessed (e.g. by reference to annual or audited accounts, or bespoke earn-out accounts) and the accounting principles, policies and practices applicable to such accounts. 

The structure of the earn-out payment(s) will also be negotiated and will vary significantly from deal to deal. Some earn-outs are binary (or “all-or-nothing”). For example, if the target achieves x million EBITDA, the seller receives a payment; if it falls short of that amount, it receives nothing. Other earn-outs use a tiered or pro-rata approach, e.g., £1.00 for every £1.00 of revenue above a baseline. The earn-out will either be paid in a lump sum at the end of the earn-out period (see below) or in instalments. Most earn-outs will be subject to an aggregate cap, limiting the buyer’s financial exposure.

An earn-out will typically be calculated over a period of between 1-3 years following completion. A seller may prefer a shorter period to get paid as soon as possible and to limit their post-completion exposure and reduce uncertainty. A buyer will usually, unless it is bound by contractual restrictions in the SPA as to how it operates the business (see below), prefer a longer period to more accurately assess the target’s financial performance.

Since earn-outs extend a seller’s financial interest in the target post-completion, they will often ask the buyer for contractual “earn-out protections”, which prevent the buyer from doing anything that could adversely affect the target’s performance. These will be particularly important if the seller is not going to remain involved in the business during the earn-out period. These might include: 

• a broad undertaking not to do anything with the intention of artificially reducing or distorting the earn-out;
• an undertaking to carry on the target’s business in the ordinary course and not to make any material changes to the business;
• an obligation not to divert business away from the target to other parts of the buyer’s group;
• restrictions on management fees or certain other costs (e.g. capex);
• an obligation to maintain the target as a separate entity or business; and/or
• an undertaking to maximise the target’s profits and/or provide a certain level of working capital (a buyer is likely to resist this).

A seller may also request decision-making rights or veto powers over key decisions (e.g. hiring or firing employees, incurring debt, paying dividends/distributions, amending the articles of association of, or winding up, the target). Most buyers will resist extensive veto rights, particularly if they extend to operational aspects of the business.

Many buyers will want sellers to remain involved in the business post-completion to ensure a smooth transition of key employees and customers, help integrate the target into the buyer’s group and achieve the relevant financial metrics/deliver the agreed business plan. A buyer might seek to achieve these aims by making the earn-out contingent on the continued involvement of the seller during the earn-out period. This raises additional issues, including:

• what happens to the earn-out if the seller leaves as a “good leaver” (e.g. death, incapacity, redundancy or constructive dismissal) as opposed to as a “bad leaver” (e.g. gross misconduct or dishonesty) – a point which is often contentious is treatment of the earn-out in the event of dismissal for material under-performance; and
• tax treatment of the earn-out payments. Sellers will want to avoid the earn-out being classified as employment income, so careful drafting and expert advice is required.

As with other forms of deferred consideration, a seller may also seek for the buyer to provide security with respect to its obligation to pay the earn-out payments (and the nature and mechanics of the security package are often heavily negotiated).

Disputes are a common issue in earn-outs, particularly with respect to calculations of financial performance and the post-acquisition management of the target. In the event that a dispute arises, an SPA will typically provide that an independent accountant will determine the correct earn-out calculation (rather than going directly to litigation, which can be costly). The SPA should also detail the manner in which such an expert will be mutually agreed between the parties and appointed, the process for the resolution of the dispute, the circumstances in which the parties can challenge an expert determination and how the expert’s fees are borne by the parties.

The buyer will typically seek to ensure that it has the ability to set-off the amount of any claims under the SPA (e.g. for breach of warranty) against any earn-out payment which becomes payable. If the seller agrees to this, it will want to ensure that the buyer’s set-off rights only apply to: 

• settled claims (i.e. agreed between the parties or finally determined by a court); or
• where a claim is still outstanding at the point the earn-out is payable, a claim which an independent expert (e.g. a barrister) has opined has a reasonable chance of success. In this scenario, the parties might agree that the buyer is permitted to withhold an estimated amount from the earn-out payment, pending final settlement of the claim.