The earn-out arrangement – an aid for uncertain times

published on 19 November 2020 | reading time approx. 2 minutes

By means of an earn-out clause in the company acquisition agreement, the parties agree to pay part of the purchase price not at the time of the transfer of the shares but at a later date. Earn-outs thus divide the purchase price into two components: the fixed component, which is payable upon closing, and the variable component, which the seller only receives at a later date after closing, provided that the acquired company achieves certain pre-defined goals. The earn-out phase being the period between closing and the payment of the earn-out component of the purchase price is generally 2-5 years.

Earn-out arrangements are often made part of the purchase price,

• if the seller retains a minority interest in the company and/or a key position with significant influence on the economic development of the company and the earn-out arrangement can thus significantly contribute to increasing the interest of the seller in a future positive development of the company, or;
  
• if the seller and the buyer have significantly differing estimates of the future development of the company's profitability and, in this respect, the basis for determining the purchase price. As the buyer usually does not consider it realistic that the improvement in the economic and financial situation of the target company planned by the seller will be achieved and can therefore already be reflected in the (fixed) purchase price at the time of closing, the buyer is often initially not willing to take this into account in the purchase price. However, the buyer is often willing to pay a correspondingly higher (total) purchase price if the company develops as forecasted by the seller.

Basis for calculating an earn-out

The earn-out is usually calculated on the basis of EBITDA as the benchmark. It is also possible to calculate the earn-out based on other income statement indicators such as EBIT, sales revenue or net profit. In addition to specifying a benchmark, the parties should agree to adjust individual items. In this respect, during the negotiations, it is advisable to define as closely as possible a list of issues to be covered by such an agreement in order to reduce the risk of later disputes as much as possible. In order to determine a long-term EBITDA, normalization issues typically identified during financial due diligence can be used as a frame of reference, such as company-specific issues, certain legal disputes, warranty, employee severance payments, site closures or the loss of certain customers or orders. The parties should also agree how, for example, extraordinary income and expenses (e.g. compensation, legal disputes, sale of fixed assets) should be taken into account. 

The aim of the adjustments is to reflect the original performance of the target company and thus to reconcile differing expectations of the seller and the buyer regarding the value that have not been resolved during negotiations based on arrangements previously made by the parties. Furthermore, this should also limit the possibilities for opportunistic behaviour on the part of the buyer.

Establishment of accounting standards

In addition to the precise definition and clarification of the benchmarks, the applicable accounting standards should also be specified. It should also be ensured that the accounting standards are applied consistently throughout the entire period covered by the calculation. They should also be consistent with the standards applied during the financial due diligence period. Should individual standards change during the period covered by the calculation, e.g. the classification of lease transactions (finance lease instead of operating lease, i.e. once recorded as depreciation and interest expense instead of other operating expenses), this should be adjusted accordingly for the purpose of adjusting the purchase price.

Conclusion

In M&A transactions, earn-outs can help to bridge differing expectations of the buyer and the seller regarding the price. However, it should always be ensured that very detailed and specific arrangements, on the basis of which the earn-out is calculated, are included in the purchase agreement. This can reduce the risk of conflict between the buyer and the seller.

For the buyer, earn-out arrangements are advantageous because they reduce the risk of an erroneous company valuation. Furthermore, it is advantageous for the buyer if he has to pay the (total) purchase price not upon closing but depending on the development of the company. The advantage of the seller is that he might achieve a higher (total) purchase price thanks to the earn-out.

In times of crisis, opportunities and risks involved in an M&A transaction are usually (very) differently assessed by the seller and the buyer. Therefore an earn-out agreement is an often selected instrument, especially in today's economic situation, as it is currently difficult to predict the future economic development.