Traditionally, when an owner sold his company, the buyer paid the entire purchase price in cash at the closing. Although the owner sometimes continued as an employee or consultant to help transition the business to the buyer, the owner was no longer personally invested in the business’s performance. Over the last few years, though, we’ve seen an increase in the number of deals with earn-outs.
An earn-out is a provision in the purchase agreement that entitles the seller to additional purchase price if the business hits agreed-upon targets—usually based on financial performance—during the period after closing. Deals that have earn-outs typically result from a difference of opinion between the buyer and the seller as to the value of the business being sold. The parties attempt to bridge that gap by agreeing that the buyer will pay the seller more for the business if the business turns out to be more valuable than the buyer thought it was.
When a deal contains an earn-out, the selling owner has a vital interest in ensuring that (1) the business performs well after closing, and (2) the terms of the purchase agreement that govern the methods for measuring the business’s performance are clear and not subject to manipulation. In addition to working out the agreement as to what the targets are and how much the buyer will pay the seller if the business fails to reach, reaches, or exceeds those targets, there are usually several other issues that the seller will want to address. Some are:
1. Will the selling owner be employed by the business?
2. How much control will the selling owner have over daily operations and major decisions that could affect the revenues and expenses of the business?
3. Does the business need to make any capital expenditures to reach its goals? How will the buyer provide assurances that those expenditures will be made, and made in time to provide the needed boost to the business?
4. Does the business need to retain any key employees? Can the buyer fire those employees without the selling owner’s consent?
There are likely to be several other issues, some unique to the business being sold.
The seller should pay special attention to the way the business’s performance, relative to the targets, is to be calculated. The seller, of course, would prefer targets that make it hard for the buyer to manipulate performance. For that reason, the seller would prefer targets that are based on revenues rather than earnings. The buyer, of course, will argue that expenses and non-cash charges like depreciation need to be taken into account as well. Sometimes the parties will agree on a mixture of earnings and revenues targets. To the extent the parties take expenses into account, the seller will want assurances that the buyer will not be allowed to charge the business for parent company or “back office” overhead.
Finally, the seller should consider what the consequences should be if the buyer breaches any of the promises contained in the earn-out provisions. Usually, the business has never before achieved some of the earn-out’s performance goals. As a result, it will be difficult to prove, to the satisfaction of the jury, that the business could have achieved those targets if the buyer had not breached the agreement. For that reason, the seller may insist that some of the buyer’s promises are so fundamental to the deal that if the buyer breaches them the seller will be entitled to an agreed-upon cash payment, in lieu of having to prove damages. Buyers will resist such a request, of course, and this is often one of the most difficult parts of negotiating an earn-out.
Of course, this is not an exhaustive discussion of the issues buyers and sellers face in fashioning the terms of an earn-out. Each business is unique, so both parties need to look closely at the factors that will affect the business’s ability to achieve the performance targets. For more information on this topic, please contact Jeff Dickerson, the firm’s senior corporate lawyer, at (512) 735-7801, or email@example.com.