An earn-out is a form of additional purchase consideration which means that the price for a company depends on future events. In other words, some of the purchase price can be paid later to the seller if certain factors are met. Usually a part of the purchase price is calculated based on the target company's earnings during a predetermined time period after the acquisition.
When to use earn-outs?
An earn-out solution may be relevant if the buyer and seller disagree or are uncertain about the target company's actual value. It is also common with earn-outs if a significant part of the target company's value is linked to the competence of individual employees. It is especially common if a buyer wants to ensure that the sellers who are active in the target company remain as active employees in the target company. Another reason may be if the target company has a short history, i.e. that there is not enough financial history for the buyer to base his valuation on.
What factors are central to determining earn-outs?
In order to set relevant goals for earn-out, the parties can of course agree on any business-related circumstances, but common factors that are usually used are; (i) business plan objectives, (ii) profit level, or (iii) sales.
Pros and cons of earn-outs
From the buyer's perspective, there are several benefits to earn-outs. The solution enables, among other things, the implementation of the transfer despite the fact that there is not enough financial information at the time of the transfer. The buyer also takes a smaller risk if it turns out that the acquired target company does not develop as expected. The buyer also does not have to pay as much at the time of access. Also, the additional purchase price can constitute a form of security for breach of warranty or contract. The earn-out also provides an incentive for the seller to contribute to the business being conducted after the takeover in the best possible way, which of course can lead to increased profitability for the buyer.
From the seller's perspective, there is a possibility that the total purchase price will increase. The seller is often given the opportunity to contribute to the business being conducted efficiently and may also benefit from synergy effects.
One of the disadvantages of earn-outs is that the buyer's commercial freedom to conduct business is usually restricted. There is also a risk of disagreement about how the business should be run and how the additional purchase consideration should be calculated.
Take into account
It is important to consider in connection with the determination of which factors should form the basis for calculating earn-out is whether the target company should be run independently or whether the target company should be integrated into the buyer's operations. The parties should also agree on the accounting principles that should form the basis for determining the additional purchase consideration, in order to prevent manipulation of the result. The buyer may want to exclude gains that are linked to synergy effects while the seller wants to include these. The parties should also consider what costs may be charged to the target company and whether they may have an impact on the additional purchase consideration.
How should the seller protect himself/herself?
For the seller, it is desirable to limit the buyer's opportunities to take measures that risk affecting the additional purchase consideration negatively. Provisions on transparency and insight into the target company's operations after access and a ban on or the seller's approval of significant measures in the target company should therefore be considered.
It should be noted that the seller's right of control and veto can have consequences linked to competition law. It should also be noted that an earn-out can have tax consequences for the seller, and both parties should therefore be vigilant about a regulation that stipulates that the additional purchase consideration is conditional on the seller or its owner remaining as an employee of the target company.