Earn-Out Clause

Summary

This clause is an all cash earn-out in which the buyer will pay to the seller additional contingent consideration based on the achievement of financial milestones measured by net income, revenue, or EBITDA. This clause contains practical guidance, drafting notes, and an alternate clause. Click here to see recent examples of publicly filed acquisition agreements containing earn-outs in Market Standards. What is an "Earn-out"? An earn-out is a deferred portion of the purchase price, or contingent payment, payable to the seller in connection with an acquisition that is based on the performance of the target business for some specified period of time after the closing of the transaction. Often, an earn-out will be described as a "bridge the gap" mechanism that allows a buyer that is concerned about overpaying for a target and a seller that believes its target business is being undervalued to reach agreement on the purchase price. When an Earn-Out Should be Used While earn-outs can be a useful tool in getting an M&A transaction to closing, they are not appropriate for all types of deals. In an acquisition, an earn-out will only be an option if the pool of recipients for the earn-out is a discrete number of sellers of the target company. An earn-out would not be used where the target was a publicly traded company prior to the acquisition, since it would be difficult (and expensive) to track down each former target stockholder following the acquisition to deliver the earn-out payment. The use of an earn-out may be suitable for certain types of businesses and business climates. An acquisition of a start-up or a company with a limited operating history is typically a good deal to incorporate an earn-out--particularly if the company has significant growth prospects that are difficult to presently value. A buyer may be willing to consummate an acquisition of a distressed or underperforming target if the payment of a meaningful portion of the purchase price is contingent on the target's future viability. In uncertain economic times, the ability to defer part of the purchase price for a target may serve to spur acquisition activity in a market that would otherwise be flat or stagnant. Benefits of Earn-Outs One of the most fundamental benefits of incorporating an earn-out provision is that it provides an avenue for parties that disagree on the value of the transaction to find a middle ground that allows the deal to proceed rather than fall apart. For a buyer, an earn-out has various advantages. An earn-out provision can make a buyer's offer more competitive where a target company has attracted multiple potential purchasers. Using an earn-out, a buyer can pay less for the target up front and shift the risk for receiving the additional portion of the purchase price to the seller that believes the future performance of the target will trigger payment of the earn-out. If a buyer is financing all or part of the acquisition of a target, the buyer is not required to obtain additional capital to cover any contingent payment since such amount will not be due until some period after closing. In fact, buyers typically will pay earn-out amounts from the revenues of the target business. Finally, by offering a mechanism to obtain additional consideration for the sale, the earn-out gives the seller the motivation to operate the business profitably and in a manner aligned with the buyer's interests, and provides an incentive for it to remain with the acquired business for some interval post-closing. Sellers obtain benefits from the use of earn-outs in a transaction structure as well. A seller's agreement to defer part of the purchase price can signal to the buyer that the seller has confidence in the future prospects of the target. An earn-out may result in a seller obtaining a higher aggregate value for the sale of the business—particularly during an economic downturn where buyers are wary of overpaying for acquisitions. If a seller is already receiving a significant portion of the purchase price up front, a contingent payment becomes pure "upside" for the seller. Drawbacks of Earn-Outs If an earn-out is not structured appropriately, both buyers and sellers can be harmed by it. For instance, a buyer may look to impede the target business's performance post-closing or manipulate the accurate measurement of such performance in order to decrease or eliminate the buyer's liability to pay an earn-out to the seller. In contrast, a seller trying to trigger and maximize an earn-out payment may run the acquired business in a way that harms the buyer in the long run to achieve its short-term goal. When targets associated with an earn-out are unrealistic, the earn-out structure can lead sellers remaining with the acquired business to become discouraged which, in turn, can affect the operation and performance of the business for the buyer. A buyer may then need to put into place new incentives to motivate a seller to enhance the performance of the target business. One of the most significant risks of a badly drafted earn-out provision is that it often leads to litigation between the parties. The complexity of earn-outs increases the likelihood that an inadequately written earn-out provision or the omission of provisions covering certain matters relating thereto will result in a dispute between the parties when determining whether the earn-out has been realized. Vice Chancellor Laster of the Delaware Chancery Court may have summarized this particular drawback of the earn-out best in his opinion in Airborne Health, Inc. v. Squid Soap, LP, 984 A.2d 126 (Del. Ch. 2009) when he wrote that "an earnout often converts today's disagreement over price into tomorrow's litigation over outcome." Drafting Pro-Buyer and Pro-Seller Earn-Out Provisions While there is great flexibility in structuring an earn-out, drafting earn-outs requires precision and attention to various details in order to avoid litigation. The principal items that must be addressed when negotiating and crafting an earn-out provision are: (1) defining the scope of the target business, (2) selecting the targets that will trigger an earn-out payment, (3) defining the appropriate accounting and/or measurement standards relating to the such targets, (4) establishing the payment structure and earn-out period, (5) establishing the parameters for post-closing operation of the target business, and (6) determining a dispute resolution mechanism. Each of these aspects of an earn-out is discussed below and in the drafting notes with a view towards highlighting pro-buyer and pro-seller considerations for each. Definition of the Target Business One of the most basic elements in an earn-out provision is defining the scope of acquired business because it is the performance of this business that will be measured in connection with the earn-out. Some matters to consider in this context include whether (1) the post-closing performance relates only to products and services of the business existing prior to closing or whether expansion of the business will be taken into account, (2) the earn-out will only relate to the performance of a particular group of products and services of the acquired business or a division of the acquired business, and (3) how sales to customers of both the buyer and seller will be treated. In addition to defining the scope of the business, the parties must ensure that they can track the performance of this business to determine whether the earn-out requirements have been satisfied. If the defined business is being operated as an independent subsidiary or division, its performance will be relatively simple to track. When a target is being integrated into the buyer's existing business, however, the parties must provide for segregated financials and special accounting allocations in order to facilitate following the defined business's performance. Establishing Earn-Out Targets The determination of the performance measure to be used in structuring the earn-out is largely dictated by the nature of the business being purchased. The measure may be a financial benchmark like gross revenues or net income. For certain businesses, however, a non-financial measure may be more appropriate if there is no historical information to use as a basis for projections. For instance, in the pharmaceutical industry, it is common to trigger an earn-out upon the achievement of certain milestones, such as getting Food and Drug Administration approval of a new drug for commercialization. Other common non-financial targets include obtaining a certain number of customers, number of products sold, or launch of a new product. Depending on the circumstances of the target company business, more than one performance measure may be used. Whether the performance measure is financial or operational, parties should strive to provide for earn-out targets that are objective and easily measurable and to make the metrics as clear and comprehensive as possible to avoid disputes. When drafting earn-outs, the parties should consider including the use of written hypothetical examples to clarify any potential ambiguities in how an earn-out is to be calculated. Accounting Standards The parties should set up proper accounting principles for measuring the established earn-out targets since general references to "in accordance with GAAP" are typically not sufficient. For instance, the parties should specify that GAAP will be applied in a manner that is consistent with either the buyer's or seller's past practice. In addition, the parties should discuss including a specific set of accounting principles as supplements or exceptions to GAAP as appropriate. Some accounting items worth considering include (1) use of cash or accrual revenue basis, (2) timing of revenue recognition, (3) revenue and expense allocation, (4) treatment of acquisition expenses and other non-recurring items, (5) treatment of intercompany transactions, and (6) treatment of uncollected receivables. Payment Structure Payments under an earn-out can be structured in a myriad of ways. Some alternatives in payment structure include (1) whether earn-out payments will be made in installments or as a lump sum, (2) whether a seller will be entitled to a percentage of an earn-out payment upon partial satisfaction of a target or whether only full satisfaction ("all-or-nothing") of the target triggers payment, (3) whether the earn-out is conditioned upon the seller's continued participation in the target business, (4) whether there will be a cap on payments, (5) whether there will be an offset of indemnification claims, and (6) whether there will be any adjustments to payments made or missed in previous periods based on subsequent performance. Earn-Out Period The period during which earn-outs are payable should be long enough to allow the post-closing business to achieve its goals, but not so long as to restrict the buyer's operation of the target for an unreasonable length of time. The length of the earn-out period may also be influenced by the nature of the payment triggers. Typically, earn-out periods range from 12 to 36 months. A buyer will want a longer period to confirm that the target business proved to be a valuable long-term investment. A seller, on the other hand, will seek a shorter period so that it will receive full payment sooner and minimize risk of losing any portion of the earn-out. As there may be an accounting impact on the buyer's financial statements based on the length of an earn-out, a buyer should ensure it understands from its auditors the effects of structuring the earn-out. In addition to determining the length of the earn-out period, the parties may negotiate whether the earn-out will include acceleration rights or buyout rights. An acceleration right protects the seller's right to receive earn-out payments in the event the buyer sells the acquired business, a bankruptcy or change of control occurs or, in the case of a seller's employee who is working for the buyer, his or her employment terminates without "cause" prior to the end of the earn-out period. A buyout right gives a buyer the right to make payment of a specified amount to satisfy the earn-out arrangement and release the buyer from continuing obligations relating to the earn-out and any post-closing covenants (discussed below) relating to the operation of the acquired business. Post-Closing Operation of the Target Business Negotiations relating to the operation of the acquired business during the earn-out period will usually revolve around two concepts: (1) the allocation of post-acquisition control over the business between a buyer and a seller, and (2) the level of support (if any) that a buyer will be obligated to provide to the business. A seller will naturally want to ensure that the target business is operated in a way that does not hamper its ability to receive an earn-out. With this goal in mind, a seller may ask for approval rights over major decisions relating to the business and/or covenants that restrict how the business may be operated to prevent the buyer from implementing changes that impact the payment or amount of the earn-out such as the discontinuation of products or services, the diversion of resources from the target to the buyer's other operations, the reduction of personnel, or the reduction in the capitalization or marketing of the business. At the very least, a seller will insist on a covenant to the effect that the business will be operated by the buyer "consistently with past practice" or in accordance with some other performance criterion. The buyer will obviously resist agreeing to any restraints on a business it is purchasing. A seller may seek not only to impose restrictions on the manner in which the acquired business is run but may also seek affirmative covenants from the buyer that require it to support the business through marketing efforts, increased hiring, and/or sufficient capitalization, or otherwise use a specified level of effort to maximize the earn-out for the seller. In contrast, a buyer's objective will be to have the right to operate the target business in its sole discretion and negate any obligation to support the business in any particular way or achieve the earn-out. Ultimately whether a seller is successful in negotiating any of the aforementioned protections will largely depend on a number of factors, including the potential impact that an action could have on the earn-out calculation and the bargaining power of the seller. Dispute Resolution As earn-outs can commonly lead to disputes, a mechanism should be in place to specifically handle such disputes and eliminate the need for relying on other dispute resolution procedures set forth in the acquisition agreement. The most common approach to dispute resolution relating to earn-outs is to provide for arbitration, with an independent accountant serving as the arbitrator. For a full listing of Corporate and M&A content, see Asset Acquisition Resource Kit, Stock Acquisition Resource Kit, Private Merger Transaction Resource Kit, Public Merger Transaction Resource Kit, and M&A Provisions Resource Kit. For further guidance on earn-outs, see Earn-Out Clauses. Earn-Out Precedents Click here to see recent examples of earn-outs in Market Standards, the searchable database of publicly filed M&A deals from Practical Guidance that enables users to search, compare, and analyze its comprehensive database of transactions using up to 150 detailed deal points to filter search results. For more information on Market Standards, click here.