Transaction Advisory: Earn-out Provisions Require Careful Planning

Earn-out provisions are often utilized in merger and acquisition (M&A) transactions to bridge gaps between sellers and buyers. For example, when the buyer cannot justify paying more than $45 million for the subject entity and the seller will not settle for less than $50 million, a carefully-structured earn-out contingency may help delay, and possibly relieve, the disagreement. The valuation disparity may be broadened when the subject entity has a relatively short operating history but high growth prospects, perhaps possessing proprietary albeit unproven technology, and may also be subject to earnings volatility.

An earn-out provision enables the seller of a business entity to receive additional compensation, post-transaction, based on the business achieving certain future performance-based goals (e.g., earnings before interest, taxes, depreciation, and amortization (EBITDA), sales or revenues, successful FDA formulation approval, new product launch, etc.). Quite often, the performance benchmarks must be achieved within a predefined period of time. If they are not achieved, the contingent payments are reduced or eliminated altogether. Although the terms of earn-outs may vary, they generally share several common features related to payment, including: (1) contingent nature, (2) delayed timing, (3) amount variability and (4) performance-based determinant.

Buyers benefit from the protection afforded by earn-outs. They are able to spread the purchase price payment over a protracted period of time and pay a price that more accurately reflects the value of the subject entity. It also enables the buyer to share performance risk with the seller, ensuring the seller remains motivated, particularly as part of the post-transaction management team. If performance benchmarks are met, the seller benefits from an increased purchase price, validating pre-transaction confidence about management strength, technological advances, product viability, synergistic benefits, etc.

Despite the appeasement they ideally create down the road, earn-outs can also fuel disagreements between the transaction parties. Earn-out provisions should be carefully structured and documented at the time of the transaction; however, it is difficult to predict every contingency. How should performance be measured? What type of performance monitoring must occur? What is the tax and accounting treatment of any contingent payment? What are the parties' responsibilities to fulfill performance obligations? When the earn-out measurement period lapses and calculations are performed to determine payment, the parties may disagree as to whether the applicable targets for an earn-out payment were satisfied. If they were not satisfied, the parties may also disagree about why the earn-out targets were not met. The Delaware Court of Chancery wrote, “[e]arn-outs frequently give rise to disputes, and prudent parties contract for mechanisms to resolve those disputes efficiently and effectively.” Aveta Inc. v. Bengoa, 986 A.2d 1166, 1173 (Del. Ch. 2009).

Therefore, to set forth the contractual language of the earn-out provision, both parties must be mindful of the features stated above that ultimately impact payment. The benchmark performance metric should be easily quantifiable and unsusceptible to manipulation or differences in interpretation. The agreement should further specify the post-transaction responsibilities of, and resources to be devoted by, both the seller and the buyer. Practical numerical examples shown in the agreement may go a long way toward alleviating disagreement upon settlement.

Given the often adverse nature of transaction structuring and earn-out negotiating, retention of qualified outside advisors (e.g., attorneys, investment bankers, tax and financial reporting accountants, valuation specialists and other professionals) at the onset will help mitigate the possibility of a disagreement between the buyer and seller while allowing both parties to focus on more immediate integration needs. Furthermore, agreeing to again retain professional assistance at the time the earn-out period lapses will increase the likelihood the calculation is performed objectively.

Bennett Thrasher has substantial experience across all service lines with designing, measuring and accounting for earn-out provisions. Please contact us if we may be of assistance in conjunction with a prior or impending transaction.

For more information on earn-out provisions or other transaction advisory matters, please contact Patrick Braley or call 770.396.2200.