Earn-outs - Key Considerations in M&A Transactions
This post was co-authored by Marek Lorenc, an articling student in our Calgary office.
In recent years, and particularly since the financial crisis, earn-outs continue to find favour in private (and occasionally public) acquisitions as a means of bridging the valuation gap between purchasers and sellers. The drafting of earn-out clauses can be challenging, as the amount of the earn-out is calculated long after the deal is done. In our experience, there are a few key thoughts buyers and sellers should bear in mind when negotiating earn out clauses.
- KISS. If an earn-out is on the table, keep the metrics simple to reduce the likelihood of future disputes and to keep management and the buyer aligned.
- Alignment. Think about motivating both parties. Earn-outs tend to work better if the buyer’s business objectives are aligned with the incentives provided to the seller.
- Type. Determine what type of earn-out makes sense. A performance based earn-out is typically triggered when certain milestones are met. Time based earn outs pay out at a specific date. Sellers will likely favour performance based earn-outs, while buyers will likely favour time based earn-outs. Both carry risks. Performance based earn-outs may be missed as a result of events over which the parties have no control, such as market volatility, diminished access to capital and weakened consumer demand. Amounts paid under time based earn-outs, unless carefully drafted, may be "managed" by the buyer.
- Measurement Periods. To reduce the likelihood of disputes, buyers and sellers will want to discuss whether it makes sense to agree on interim performance measurements. Measurement periods will typically be tied to payment frequency.
- Payment Frequency. If an earn-out is time based, volatility in the operations or financial results of a target, whether or not due to current market conditions, may have a serious impact on the earn-out. A longer earn-out period increases the likelihood of potential disputes, while a shorter earn-out period may not enable the seller to realize the full value of an earn-out. Payments on the earn-out can be made monthly, quarterly, annually or at the end of the earn-out period. Generally, the more frequently payments are made, the less likely there will be a dispute.
- Method of Calculation. While EBITDA, EBIT and net income are commonly used indicators of post-closing earnings, these measures are subject to interpretation. Try to have a third party financial professional review the earn-out clause before signing to ensure that the method of calculation will be interpreted the way the parties think it will. While this will not prevent disputes, it may reduce their likelihood. In determining which method of calculation to use, generally, purchasers will favour net income, as it will tend to be more consistent with a purchaser’s own internal method of valuing the target after closing whereas sellers, in order to avoid potential distortions between pre and post-closing operations and capital structure, will likely favour EBITDA or EBIT.
- Post-Closing Synergies. Buyers will want to consider a reduction in the amount of the earn-out where there are valuable post-closing synergies to be realized, such as reductions in personnel, shared services and other integration benefits.
- Taxation. Both buyers and sellers will want to maximize the tax efficiency of an earn-out so tax advisors should be involved in the drafting of the earn-out clause. The structure of an earn-out may affect the characterization of the income derived therefrom (ie. capital gain or income) and may result in greater tax liability.
- Dispute Resolution. Inevitably disagreements will arise with respect to the calculation of and entitlement to, earn-out payments. Buyers and sellers will want to consider an arbitration or other dispute resolution provision which includes (a) the appointment of a financial expert to act as arbitrator, (b) the confidentiality of the arbitration and (c) specific guidelines as to what methods of calculation should be used.
- Termination of the Earn-Out. Earn-outs often restrict a purchaser’s flexibility over the target’s operations. Future potential acquirors may be discouraged from acquiring assets encumbered by an earn-out. If an earn-out is contemplated in a situation where the buyer believes it may want to sell the target before the earn-out is paid, buyers will want to negotiate a buy out option for the earn-out up front.
earn-out EBITDA private M&A valuation