Earn-Out Provisions, Seller Beware

When selling a company, it is sometimes the case that part of the purchase price payable to the seller is payable on deferred terms. If the deferred part of the purchase price is linked to the future performance of the business over a specified period of time, such part is often called an “earn-out” payment.

If the transaction structure includes an earn-out, the terms and conditions associated with the earn-out will be set out in the share purchase agreement (SPA). Such terms and conditions typically specify that the earn-out is based on the business achieving some measure of financial performance over a given period of time. For example, such a measure could be linked to sales revenues or profits realised during the earn-out period.

In some cases, the seller may be retained in the business during the earn-out period, and so may have visibility of the future performance of the business in order to verify whether the earn-out conditions have been satisfied. However, if this is not the case, then the seller will be reliant on information provided by the buyer.

Earn-out considerations for sellers

Following completion of the sale, the buyer will have complete control of the business and will be free to operate the business in whatever manner they see fit.

However, the risk for the seller is that the buyer could take action in the business, which has a detrimental effect on the seller’s ability to receive the earn-out.

Examples of such action could include the following:

• Diverting business away from the company in question, perhaps to another company owned by the buyer.
• Where the earn-out is profit-based, taking steps to reduce the profit by, for example, making intra-group management charges or paying bonuses to the buyer’s incoming management team.
• Making material changes to the previous business model.
• Transferring the business of the company in question, perhaps to another company owned by the buyer.

In order to mitigate the above risks, sellers should always try to include protective measures in the SPA, placing controls over what the buyer can and cannot do in the business during the earn-out period.

However, buyers are typically resistant to such measures and often argue that having bought the company, they should be free to operate it as they see fit.

The counter-argument from sellers is, of course, that they should be entitled to protect their earn-out. In other words, the buyer and the seller have conflicting requirements, and the end result is often a compromise position, by which the seller gains a degree of protection, but in less than ideal terms.

Particularly in circumstances where the seller will not remain in the business, it is important that the SPA specifically provides information rights for the seller to permit verification of the relevant financial performance. The basis, procedure and methodology for calculating the earn-out should also be detailed in the SPA, together with a dispute resolution mechanism in case the buyer and seller cannot agree on the final position.

Conclusion

For the above reasons, earn-out structures will always carry an element of risk for sellers and are often based, at least in part, on a degree of compromise and trust by the seller. Perhaps the most obvious risk for sellers is that such trust may be misplaced, and the reality is that a disingenuous buyer could probably find a way to reduce or eliminate the earn-out if they were sufficiently motivated to do so.

The Corporate and Commercial team at Wilson Browne Solicitors regularly advises either sellers or buyers on all aspects of company sales and purchases, including transaction structures which include earn-outs.

For a confidential and no obligation initial discussion about how we may be able to help, please contact the Corporate and Commercial team on 0800 088 6004 or fill in our online form