When buying/selling a business, it is always important to consider what mechanism is best suited for the purchase price.
The parties will consider whether the purchase price should be made in full at the time of completion of the purchase/sale or partly on completion and partly contingent on the business's future performance.
An earn-out provision is a pricing mechanism whereby an element of the purchase price in a purchase agreement is contingent on the company's future performance.
Earn-out provisions are more commonly utilised when dealing with mergers and acquisitions; in particular, they are more common in share purchase agreements.
An earn-out provisions is essentially used to bridge valuation gaps between the buyer and seller and is often used in high-growth businesses where the business today may be worth a certain figure but in the future should be worth more.
An earn-out provision can also act as a management incentive where owner-managed businesses are sold, and the managers continue to work for the target for an agreed period following the sale.
Usually, an earn out clause is preferred by the buyer; however, there are some advantages to both parties in a transaction:
The buyer can retain the expertise of the seller(s) in the company after buying the business. In addition, the buyer will also be able to defer part of the purchase price to a date in the future.
An earn-out provision also encourages the seller to remain in the business following completion and attempt to make the business a success.
The parties may have conflicting interests, as the seller(s) will want to maximise the purchase price, whereas the buyer may want to keep the purchase price at a lower level.
The seller(s) will also want to ensure that the buyer does not do anything that restricts the business's growth and thus restricts their ability to hit the earn out targets, which can lead to a difficult relationship between the parties.
Depending on the terms of the earn out, it allows a seller to benefit from a positive development of the company, as an earn out will usually be contingent on the positive performance of the company.
The earn out could also allow the seller to benefit from synergies in the buyer's group, potentially leading to the seller maximising returns.
An earn-out clause will bring uncertainty to a seller as a portion of the purchase price will be subject to the company achieving a certain objective/target.
It may also be the case that a particular market suffers from outside factors outside of the seller's control (e.g. the covid-19 outbreak).
If you need help buying or selling a business, or you need some advice regarding earn-out provisions, speak with our Corporate Team. You can contact our Corporate Solicitors on:
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