What is an earn-out?
An earn-out is a common arrangement in business sales where part of the purchase price is deferred and dependent on the future performance of the company. Specifically, a portion of the purchase price is paid after the transfer of the business, and the amount of these payments varies based on the achievement of certain financial targets, such as profit (EBITDA).
Why an earn-out?
An earn-out provides a solution for the differing assessments of future opportunities and risks by the buyer and seller. While the buyer often worries about potential risks, the seller sees significant potential and growth. By agreeing on an earn-out, a portion of the business risk remains with the seller, while the buyer assumes less risk. This can also be positive: if profits grow, the seller receives a higher purchase price.
Legal position in an earn-out
According to case law, the buyer must continue the activities of the acquired business optimally to achieve the highest possible profit, benefiting the profit-dependent purchase price. However, this duty of effort conflicts with the buyer's entrepreneurial freedom to manage the business as they see fit. This can create a conflict of interest, as the buyer may be inclined to manipulate costs, revenue, and margins to minimize the earn-out.
Key agreements in an earn-out
A good earn-out arrangement always includes agreements on how the buyer will continue to run the business. This provides the seller with some control and helps manage business risk. The following elements are commonly found in an earn-out agreement:
Unchanged business operations: The buyer commits to continue business operations unchanged, often reinforced with a prohibition on making significant decisions without the seller's prior consent.
Consequences of non-compliance: There are consequences if the buyer does not adhere to these obligations, such as a provision that the purchase price is fixed and immediately payable upon breach.
Access to financial records: The seller receives full access to financial records to monitor what has happened.
Fixed payments and access to financial records are crucial to strengthen the seller's position in any disputes over settlement.
Conclusion
An earn-out can be a useful solution to bridge uncertainties in the purchase price, especially in turbulent times. It offers a flexible approach to evenly distribute risks and opportunities between buyer and seller. However, it can also lead to disputes if the buyer tries to divert margin and profit. An attentive seller should therefore arrange their position well in advance and make clear agreements to prevent problems.
With a well-thought-out earn-out arrangement, both parties can benefit from the future performance of the business and achieve a fair distribution of the purchase price.
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