Key Considerations in Earn-out Provisions in Private M&A

An earn-out is a mechanism whereby the parties in an M&A transaction link a portion of the purchase price to the future performance of the target business after closing.

In a mergers and acquisitions (“M&A”) transaction, earn-outs can be a double-edged tool for purchasers and sellers when negotiating their purchase agreement. A purchaser and seller may choose to include earn-out provisions when they cannot agree on the value of the target business. This is often done with the intent of bridging the gap between what the purchaser is willing to pay to purchase the business and what the seller agrees to charge as a purchase price.

Sometimes, we refer to a similar, but reverse concept called “reverse earn-outs”, whereby the purchase price is reduced after closing to the extent the target company fails to achieve a certain performance threshold.

There are several challenges and difficulties underlying earn-outs that can add to the complexity of the negotiations between purchasers and sellers. If not drafted clearly and with intention, earn-out provisions can be a source of costly and stressful disputes between the parties.

Understanding Earn-Out Provisions

An earn-out is typically structured as one or more conditional payments of a purchase price which are payable after closing when certain specified thresholds or targets are satisfied within pre-determined periods of time.

Such specified targets may be financial, non-financial, or a combination of the two. Financial targets may be based on projected revenues, EBITDA, net equity, earnings per share, or if the target company ultimately gets listed in the public market.

Non-financial targets may be based on a minimum number of new customers. They may also be based on sales volumes or the business achieving a certain patent, license, or a regulatory approval.

In a well-drafted agreement, if the specified targets are met by the acquired business, the purchaser must make the agreed upon payments to the seller at the specified periods of time. If, however, the acquired business fails to achieve such targets at the required time periods, the purchaser is relieved from making the conditional payments; or, in some instances, is only required to pay a reduced amount.

Advantages and Disadvantages of Earn-Outs in Deal Structuring

Earn-outs carry various pros and cons for both purchaser and seller and each party should carefully undertake a cost-benefit analysis during the negotiation process. In some instances where the disadvantages outweigh the advantages, it may be impractical or inadvisable to use an earn-out.

The Purchaser’s Perspective

From the purchaser’s perspective, earn-outs can be used for the following purposes:

• When purchasers have limited access to funds (such as when debt financing is not readily available) or wish to avoid relying on third party financing;
• When purchasers wish to allocate risk by having some of the purchase price be contingent on the amount of revenue (or other financial targets) achieved by the business in future post-closing periods;
• To protect the purchaser from overpaying by valuing the target business more accurately, based on the actual future performance of the business rather than on past performance or forcasts of future performance;
• To motivate the sellers to maximize the profitability of the target business;
• To offset indemnification claims under the agreement against the seller; and
• To distinguish the purchaser from other bidders by offering a higher purchase price.

Conversely, the purchaser must also consider the potential disadvantages of an earn-out which include the following:

• The purchaser’s ability to direct the business strategy of the acquired business may be significantly hindered as the seller would typically seek to restrict the purchaser’s ability to make significant changes to the business; and
• The long-term performance of the business may be compromised in favour of maximizing the short-term gains.

The Seller’s Perspective

From the seller’s perspective, earn-outs can be used for the following purposes:

• They can provide the seller with the opportunity to receive a higher purchase price than they would have otherwise received; and
• The seller can benefit from the target business being assimilated with the purchaser or the purchaser’s business, which may carry the potential of the business performing better than it would have on its own. In turn, this may enable the seller to achieve a greater payout.

Conversely, the seller must also consider the potential disadvantages of an earn-out which include the following:

• Earn-out arrangements can prevent the sellers from having a clean break on closing as they continue to be invested in the business for an extended period of time after the close of the transaction;
• The seller can be at the whim of economic downturns or the purchaser’s actions and business decisions, and the seller may thereby lose its earn-out potential as a result of actions or circumstances that are outside of the seller’s control; and
• If the purchaser brings an indemnification claim, the seller’s earn-out may be used to set-off such payments.

Considerations in Negotiating Earn-Out Provisions

Earn-outs can be “all or nothing” depending on if the threshold is met, or they can be calculated on a sliding scale. They are entirely customizable and careful attention must be paid when negotiating the various terms.

The Purchaser’s Perspective

The purchaser may want to add more certainty to their earn-out obligations by capping the earn-outs at a specified amount, even if the target business exceeds its performance targets. This would add more predictability and allow the purchaser to allocate and manage its finances more effectively.

In addition, the purchaser may wish to negotiate certain covenants that limit the seller’s post-closing involvement in the target business or the seller’s right to object to the manner in which the operation of the target business get conducted. Typically, earn-out provisions will allow the purchaser to operate the business in its sole discretion, subject only to expressly stated limitations, and a general obligation not to act in bad faith by depriving the seller of the earn-out.

If the seller owes any amounts unrelated to the earn-outs that are owing to the purchaser, the purchaser may use the earn-outs as a mechanism to set-off any amounts owing to it under the purchase agreement.

Further, the purchaser can require the earn-out payments to be subject to a holdback wherein the purchaser deposits the earn-out payments in escrow in order to create a form of security over certain seller liabilities, such as indemnification claims. If the purchaser claims any indemnifications during the earn-out period, they would be able to more easily recover such costs from the escrow holdback.

The Seller’s Perspective

If the purchaser intends to make any post-closing corporate changes to the target business (e.g., amalgamating the target business with an existing entity) or plans to cause it to incur significant expenses, then these matters should be taken into account when negotiating the earn-out thresholds. The seller should consider requiring the purchaser to obtain the seller’s consent for any change of control during the earn-out period.

Depending on the earn-out thresholds used, a purchaser may want to have a say in how the target business is run. The earn-out provisions can require the seller to have a contractual approval right or veto right over certain major decisions and include specific covenants for the purchaser during the earn-out period. Furthermore, the seller may consider adding to the agreement a liquidated damages amount if the purchaser breaches any covenants relating to the ongoing operation of target business during the earn-out period.

It is strongly advisable for the seller to conduct due diligence on the purchaser to determine its creditworthiness as the seller will be relying on the purchaser to pay the earn-out payment if and when due. Further, the purchaser may want to ask for personal guarantees or security over the obligations, and require that interest accrues on any late payments.

The purchase agreement may also provide for the earn-out payments to be immediately due to the seller upon the occurrence of certain events. Such events include the bankruptcy or insolvency of the purchaser, the termination of key employees of the target business, a breach of covenants by the purchaser or a certain action that is detrimental to the financial well-being of the business, or in the event that the purchaser sells the acquired business or a significant amount of its assets.

Disputes

Given their nature, earn-outs carry a significant potential for disputes and many such disputes arise due to the ambiguity in drafting the purchase agreement.

One Ontario case that demonstrates the importance of clear drafting in earn-out provisions is Whiteside v. Celestica International Inc., 2014 ONCA 420 (“Whiteside”).  In Whiteside,  the purchase agreement provided that the earn-out payment be calculated using a formula based on EBIAT (earnings before interest, amortization and taxes). During the last earn-out period, the company obtained a very profitable contract that, if included in the calculation of the earn-out, would have resulted in an earn-out being paid to the seller, but if excluded, would result in no payment being owed. The purchaser chose to exclude the contract from the calculation based on a narrow interpretation of the earn-out calculation terms. The trial judge ruled in favour of the purchaser. However, the Ontario Court of Appeal later reversed the trial judge’s decision by holding that the new contract should have been included based on a broader interpretation of the agreement, the letter of intent, and the fact that the purchaser had included similar contracts in earlier earn-out calculations.

Other Considerations

The complexity of earn-out provisions extends well beyond those discussed in this article. Purchasers and sellers are strongly advised to seek appropriate accounting advice as earn-outs can lead to adverse accounting treatment if matters such as the fair value of the earn-outs or the applicable accounting principals are not properly considered.

In addition, the tax treatment of the earn-out payments should be top of mind for both parties, and in particular, for the seller. As such, it is crucial for purchasers and sellers to obtain specialized tax advice when structuring the deal to allow for a tax efficient outcome and to anticipate any tax liability

Key Take-Aways

• Invest the time to draft clear and thorough earn-out provisions that provide for objective measures and avoid any subjective determinations. If subjective determinations are required, include clear guidelines or references to acceptable past practices.
• Take into account the unique nature and industry of the target business and, while difficult to predict, consider any anticipated developments in the economy that may impact the projections of the business.
• The purchase agreement should include robust provisions for how earn-out disputes would be resolved with the aim of facilitating a fair and cost-effective mechanism for dispute resolution and reducing uncertainty.
• The post-closing conduct of the parties is of great importance and may be taken into account by a court when deciding if a specific earn-out is owed. As such, it is advisable for parties to consult with their legal advisors when interpreting their earn-out provisions and managing any post-closing disagreements.
• Defining and setting up financial targets involves many complex legal and accounting considerations and the parties should consult with their accountants and tax advisors when determining the financial targets to be used in the earn-out.