In mergers and acquisitions, the negotiation of the purchase price and its payment terms is key to a successful transaction. Typically, the purchase price is based on an agreed-upon valuation method. Buyers aim to acquire target companies at a value that reflects their investment criteria, while sellers seek to maximise the return on their equity. A common feature in these agreements is the inclusion of an earn-out payment provision. This provision allows for the adjustment and deferred payment of the purchase price, offering a balanced approach to finalising the purchase price.

Our previous article on mergers and acquisitions provided a general overview of these transactions. This article will focus specifically on earn-out payments, which are frequently used in private acquisitions. We will discuss the structure of earn-out payments, their role in transactions, and important considerations for both buyers and sellers.

Understanding earn-out payments is crucial for anyone involved in mergers and acquisitions. Properly structured, they can provide a flexible and efficient way to bridge valuation gaps between parties.

What is an Earn-Out Payment?

An earn-out payment is essentially a portion of the purchase price in a merger or acquisition that is deferred and contingent upon the future performance of the acquired company. This payment mechanism allows part of the purchase price to be paid later, based on specific performance metrics agreed upon in the definitive agreement.

For instance, the performance could be measured by the revenue or profits generated by the target company over a set number of years after the deal is completed. This approach helps align the interests of the buyer and seller: the seller is incentivized to ensure the continued success of the business, often by staying involved in operations, while the buyer mitigates the risk of overpaying for a company whose future performance is uncertain.

Typically, the total purchase price in an earn-out agreement is paid in tranches: an initial payment made at the execution of the definitive agreement, a subsequent payment at the completion of the deal, and then additional payments based on the agreed earn-out criteria by a certain date.

Earn-out agreements can vary widely. They might use different metrics to measure success, cover different time frames, or have various conditions attached. Understanding these nuances is critical for both buyers and sellers to negotiate a deal that accurately reflects the value and potential of the target company.

Incorporating an Earn-Out Payment

If parties agree to incorporate an earn-out payment in an acquisition deal, there are many factors that the parties should consider, such as:

  1. Employment and Retention: Will the sellers be employed or retained as directors or key management post-completion? What provisions exist if they or other key employees leave during the earn-out period?
  2. Payment Structure: What proportion of the purchase price is subject to the earn-out? Is it based on fixed revenue targets or an adjustable scale?
  3. Performance Metrics: What indicators or measures will determine the revenue targets? What accounting standards will be applied?
  4. Revenue Calculation: Will the revenue be calculated as gross or net?
  5. Payment Cap: Is there a maximum cap on the earn-out payment?
  6. Earn-Out Period: What is the duration for achieving the revenue targets, and is it reasonable?
  7. Payment Terms: How will the earn-out payment be processed upon determination of the amount?
  8. Set-off Rights: Are there any rights to set off against the earn-out payment?
  9. Acceleration Events: What events during the earn-out period may trigger accelerated payment of the maximum earn-out to the seller?

Understanding and addressing these factors in the definitive agreement is essential. A comprehensive agreement reduces the risk of future disputes and ensures both parties have a clear understanding of the earn-out’s structure, mechanisms, and terms. The ultimate goal is a mutually agreeable structure that reflects the parties’ interests and objectives

Illustration of an Earn-Out Scheme

For the ease of reference and understanding, the table below shows a simple illustration of an earn-out payment scheme:

Framework of the Earn-Out Scheme

The Assessment Scale for the Earn-Out Amount

Conclusion

Incorporating earn-out payments in acquisition transactions offers a strategic solution for aligning the interests of both purchasers and sellers. For purchasers, it provides a safeguard against overpaying, tying part of the purchase price to the future performance of the target company. Sellers, on the other hand, benefit from the potential to maximise their return through post-completion involvement in the company, steering it towards achieving specific profitability goals.

This arrangement is particularly advantageous when the future profitability of the target company is uncertain. It allows purchasers to mitigate risk while offering sellers an opportunity to prove the value of their company and earn accordingly.

To ensure clarity and fairness in these transactions, it is crucial to negotiate and potentially cap the earn-out amount. This approach establishes clear parameters for the final purchase price, providing certainty and setting realistic targets for both parties. We recommend that parties involved in M&A consider earn-out payments as a flexible tool for bridging valuation gaps. Proper negotiation and structuring of these payments can lead to successful, mutually beneficial transactions, balancing risk and reward for both buyers and sellers.

If you are entering into an M&A transaction and would like us to advise you on the transaction, feel free to contact us, and we will be pleased to assist you with your matter.

By Tommy Wong

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Note: This article does not constitute legal advice to any specific case. The facts and circumstances of each and every case will differ and therefore will require specific legal advice. Feel free to contact us for complimentary legal consultation.