Simply put, an earn-out agreement is a contractual prearrangement in an acquisition which mandates that the seller receives additional compensation if the business reaches its discussed financial goals over a specific time frame following the sale.
In some instances, this purchase arrangement can be a separate arrangement within a merger or acquisition’s documentation.
It may appear that the earn-out is mainly set to benefit the vendor as it ensures the maximum possible return on a sale, but if arranged appropriately in certain circumstances, there is no reason why it cannot be a win-win situation for both the buyer and the seller.
In its most basic structure, an earn-out calculates the company’s current and potential purchase value using predicted future revenue figures. This determines the value of the sale and can prove beneficial to both the buyer and seller as it cements a business deal. Having an earn-out ensures that a buyer does not have to front all the cash at the point of sale, but instead can leverage the business to pay for some of its own purchase costs.
Who did it rightTake, for example, Vianet Group’s acquisition of Vendman Systems with a successful earn-out in place. The £4.2 million sale, payable in cash, resulted in a sizeable earn-out of £2.25 million based on targets achieved in the first two years. The remaining £2 million was funded by a bank loan. In due course, the earn-out gave Vianet the financial leeway to make the strategic acquisition, extended the capabilities of both companies, and boosted business growth for all parties involved.
What are the risks?However, those in the acquisition market remain cautious of earn-outs due to certain risks. These include:
Where it went wrongA buyer’s ideal scenario is that the seller just misses out on earning targets, i.e. the company hits high sales and profitability but not quite enough to trigger earn-out payments.
How to do it rightThat said, to avoid a situation like what Drury was in, sellers can mitigate the risks by establishing targets that consider the effects of the post-purchase lag. Earn-outs are already complex transactions with many significant periods of ‘unknown’ for both parties, but when structured and applied appropriately, they can yield positive financial rewards for the seller and give buyers some assurance in that they will avoid overpaying on untested potential.
What precautions to takeBy no means is incorporating an earn-out agreement into an acquisition deal the simplest or quickest process, but the potential gains can be worth the time and effort. When negotiating the deal, the seller should seek to keep as much control as possible over the assets and the budget, and any major future operations. The contract ought to include provisions to protect the seller’s interests and should penalise the buyer if the agreed conditions are not adhered to. It may also be possible to guarantee a minimum payment for the earn-out.
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