Earn-Outs in M&A Transactions

Does an earn-out plan create a fair deal that makes everyone happy or a fast track to disputes and litigation?

By Delzad Kutky

What are Earn-Outs?

An earn-out is a contractual process often seen in the purchase or sale of a business where a part of the purchase price is variable and depends on the performance of the business after closing. Some people conceptualize earn-outs as a sort of “performance bonus” which allows the final purchase price to be variable and tied to the business’ future performance.

Earn-outs are more common in mergers and acquisitions (M&A) transactions that involve start-ups, businesses that are actively growing, or companies working in particularly uncertain industries. In these situations, a purchase price based on the current financial health of the corporation may not fairly reflect what the business can be worth in just a few months or years’ time. Businesses that are well-established, operating in more stable markets, or that aren’t experiencing uncharacteristic growth or loss, on the other hand, may not need to have their value tied to an earn-out clause.

How do Earn-Outs Work?

Earn-outs can be structured in many different ways and incorporate a variety of milestones. A common structure is to have a buyer pay a fixed amount at closing and then agree to make additional payments to the seller if the business hits specific performance targets. Performance targets are usually associated with financial metrics such as EBITDA, net profit, or gross revenue. However, they can also be tied to other goals such as customer retention or securing governmental approvals or permits.

From the buyer’s perspective, an earn-out can be a great tool to ensure they aren’t overpaying for a business that could fail shortly after closing. On the other hand, sellers often see earn-outs as a delay to getting a fair price for what they believe the business is truly worth, so if they agreed to an earn-out process, the total purchase price (including performance target payments after closing) should be higher than the purchase price if they sold the business for a lump sum amount on closing.

What to Consider When Negotiating Earn-Outs

There are several options that can be tweaked to meet each party’s business needs when negotiating and drafting an earn-out process in an M&A agreement, and any ambiguity or uncertainty about any of those choices are likely to result in a dispute between the buyer and seller. This is why thoughtful negotiating and drafting is essential.

One of the most important points to negotiate is what the performance targets will be and just as importantly, how those targets can be objectively measured. Calculation processes, accounting practices, and the overall objectives should be clearly defined to ensure the parties aren’t in a situation where the seller thinks a target was met but the buyer disagrees. An earn-out clause should also set a specific timeline for the earn-out period and how often payments will be made during that period.

It’s also important to consider how the business will be carried out after closing during the earn-out period. Sellers may fear that a buyer will not operate the business as well as the seller would or that the buyer may even deliberately stall growth or damage the business to avoid having to make further payments. To that end, a seller may want contractual restrictions on how the business can be carried out and strict reporting or inspections for them to be sure the buyer isn’t at fault for any performance issues with the business. On the other hand, buyers typically don’t want a seller to interfere in their business after closing and don’t want to limit operational flexibility and how the buyer feels they can best grow the business.

Furthermore, having clear procedures in place for reporting performance, reviewing calculations, and resolving disputes that may arise is extremely important. A well-drafted earn-out mechanism can significantly reduce the risk of costly disputes and help keep the earn-out process running smoothly.

How to Earn the Best Result When Considering an Earn-Out

A conversation with one of our corporate lawyers (whether in our Markham office, or via video call) is the first step to putting a plan in place for the purchase and sale of a business. Legal advice and skilled negotiating can help you avoid being taken advantage of in a transaction where an earn-out is present.  

The experienced corporate lawyers at SorbaraLAW are ready to assist with your purchase or sale of a business. We can assist you with determining whether an earn-out is the right choice for your transaction and with negotiating, drafting, and implementing an earn-out mechanism to ensure you aren’t trapped in a bad deal or on the fast track to a dispute.