Expert Focus: Negotiating earn-out provisions in Canada
April 15, 2024
Chambers Expert Focus articles provide an in-depth look with insights and analysis of the key stories and trends affecting the market.
SkyLaw is a regular contributor to Chambers publications. You can find below or online here our recent Expert Focus article on negotiating earn-out provisions in Canada.
Getting the Maximum: Negotiating Earn-Out Provisions in Canadian M&A
Contents:
Introduction
Canada has a rich entrepreneurial environment. Both public and private acquirers outside Canada frequently bid for sophisticated, privately-held Canadian companies. The authors specialise in these kinds of cross-border transactions.
The Use of Earn-Outs
An earn-out is a mechanism whereby the purchaser defers payment of a portion of the purchase price until after closing. The deferred portion could be contingent on the future performance of the target’s business after closing, the achievement of certain key milestones, or other thresholds.
Earn-out provisions can help bridge a valuation gap and help reduce the risks to the purchaser.
It will generally be in the seller’s interest to minimise both the portion of the purchase price subject to the earn-out, and the period of time in which the earn-out occurs. Earn-outs can, however, be a double-edged sword and may lead to disputes if not drafted clearly and with careful planning.
Both purchasers and sellers must pay close attention to earn-out provisions when negotiating their purchase agreements to avoid any adverse legal and accounting consequences.
Advantages and Disadvantages of Earn-Outs
Purchaser’s perspective
From the purchaser’s perspective, earn-outs can provide the following benefits:
- the purchaser can defer paying a portion of the purchase price, which may make financing the purchase easier, and may in turn allow the purchaser to distinguish itself from other bidders by offering a more attractive purchase price;
- an earn-out can incentivise the founder to maximise post-closing performance;
- the purchaser can reduce its risk as compared to calculating a fixed purchase price on closing; and
- the purchaser can offset indemnification claims against the earn-out payment.
Conversely, the purchaser must also consider some potential disadvantages:
- the purchaser’s ability to direct the strategy of the acquired business may be hindered as the seller will 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 maximising the short-term gains during the earn-out period.
Seller’s perspective
From the seller’s perspective, earn-outs can be used for the following purposes:
- the seller may be able to negotiate a higher purchase price than it would have otherwise received; and
- during the earn-out period, the target can benefit from being aligned with the purchaser, offering efficiencies that make it easier to hit the earn-out thresholds.
Conversely, the seller must also consider some potential disadvantages:
- earn-outs can prevent the seller from having a clean break on closing as it must continue to be invested in the business after the close of the transaction;
- the seller may lose out on its return as a result of factors that are outside of the seller’s control, such as economic downturns, customer departures, or the purchaser’s actions; and
- the earn-out may easily be used to offset payment obligations, such as indemnification claims, which the purchaser might otherwise have to work harder to pursue.
Negotiating Earn-Out Provisions
Purchaser’s perspective
Earn-outs are entirely customisable and can be “all or nothing” (ie, depending on whether a certain threshold is met), or they can be calculated on a sliding scale. Using a sliding scale can reduce the likelihood of a dispute.
The purchaser will likely want to cap the maximum earn-out payment.
The purchaser should consider its plans for the target post-closing and expressly stating the extent to which they will or will not affect the earn-out, such as corporate transactions or restructurings, changes in business, and changes in accounting practices.
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 is conducted.
Seller’s perspective
Generally, it will be in the seller’s interest to minimise both the portion of the purchase price subject to the earn-out, and the period of time in which the earn-out occurs.
The seller should consider asking the purchaser for covenants that, during the earn-out period, the business will be run in a manner that represents the ordinary course. The seller may also require the purchaser to obtain the seller’s consent for any material changes to the business during that time.
Parties are advised to seek appropriate accounting advice, as earn-outs can lead to adverse accounting treatment.
Further, to provide comfort that the earn-out will be paid, the seller can require cash to be set aside by the purchaser. The seller may also want to ask for personal guarantees or security over the payment obligations and conduct due diligence on the purchaser to confirm its creditworthiness.
The purchase agreement may also provide for earn-out payments to be immediately payable to the seller upon the occurrence of certain events, such as a change of control, the bankruptcy of the purchaser, the termination of key employees of the target business, or the purchaser’s breach of its covenants.
Other Considerations
Parties are 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-out or the applicable accounting principles are not properly considered. The tax treatment of the earn-out payments should be top of mind for both parties, and for the seller in particular.
Takeaways
- Ensure unambiguous and thorough drafting of earn-out provisions that provide for objective measures and avoid 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 consider any anticipated developments in the economy that may impact the performance of the business.
- Prepare models of sample earn-out periods and payments (for example, based on prior financial statements of the target). This can also help flush out any business and accounting considerations that need to be documented along the way.
- Include robust language for how earn-out disputes will be resolved with the aim of facilitating a fair and cost-effective mechanism for dispute resolution.
- Involve a knowledgeable accountant or tax advisor when determining financial targets and considering any associated tax liabilities.
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