- Earn-Out Constructs: Getting the Matrix Right
- July 23, 2016
- Law Firm: Duane Morris LLP - Philadelphia Office
“The carrying power of a bridge is not the average strength of the pillars, but the strength of the weakest pillar.” - Zygmunt Bauman
When there is disagreement over the profitability or future earnings prospects of a company being sold, buyers and sellers may choose to use an earn-out mechanism to bridge their differences. An earn-out mechanism allows part of the purchase price to be based on a company’s future performance. Earn-outs are popular in transactions that are people- or services-based, or that involve businesses with good prospects but a short track record.
However, earn-out mechanisms should be properly structured in order to lower the risk of future disputes. This should be a joint task undertaken by buyers’ and sellers’ legal counsels, accountants and financial officers.
In designing earn-out mechanisms, three key areas are relevant:
- how an earn-out payment is calculated and paid,
- regulating buyer and seller behaviour during the earn-out period and
- how earn-out disputes can be resolved.
Unhappy sellers may allege that buyers manipulated calculations of company performance to lower the earn-out payment amount. They may also allege that buyers did not measure the company’s performance as was planned when they agreed to the earn-out.
To lower the risk of disagreement, sound performance metrics should be used in an earn-out mechanism. Performance metrics can be non-financial, financial or both.
When performance targets are achieved, earn-out payments can take a number of forms.
Non-financial performance metrics
Non-financial performance metrics are transaction-specific: for example, if a new contract with a key customer is secured by the company or if an agreed-upon number of new customers are secured by the company.
Financial performance metrics
The choice of financial performance metric will vary on a case-by-case basis. Such metrics are often pegged to EBITDA, revenues or net income.
For example, buyers may ask for bottom-line earn-out metrics pegged to EBITDA. If sellers generate added value in EBITDA during the earn-out period, this will entitle them to earn-out payments. However, sellers may not be comfortable with this approach, as it is susceptible to the buyer’s ability to affect the earn-out via buyer control of the company’s operational and financial decision-making.
A seller who wants to lower the risk of buyer manipulation of an earn-out might therefore ask instead for a top-line earn-out metric pegged to revenues. Buyers, however, may not be comfortable with this, as it could encourage sellers who stay with the company after it has been sold to focus on increasing short-term sales without taking into account other factors (such as long-term considerations for the company’s business).
As a compromise, buyers and sellers may agree to settle on a middle-ground earn-out metric pegged to gross profit margins. It is also possible to use a hybrid approach combining more than one financial metric.
How an earn-out is paid
An earn-out payment can be structured as a fixed amount or a variable amount. Fixed earn-out payments take an all-or-nothing approach. Variable earn-out payments can be pegged to a multiple (or percentage) of the amount by which the company’s performance exceeds the earn-out target or can be scaled according to actual company performance.
Buyers will likely wish to be protected from over-paying if unsustainably large profits are made during the earn-out period. To do so, they may want to impose a maximum limit on the earn-out payment.
The form of earn-out payment can be in cash, loan notes or non-cash consideration, such as shares in the capital of corporate buyers. However, non-cash consideration has potential risks. This is demonstrated in a transaction from the UK. The sellers of a property consultancy company agreed to a large earn-out component paid in the shares and convertible loan notes of the buyer, a listed company. The buyer’s share price plunged subsequently, and the sellers’ shares and convertible loan notes in the buyer became almost worthless. They therefore lost half of the sale consideration they had negotiated.
Separately, sellers may negotiate for earn-outs to have carry forward or carry backward provisions. These provisions are useful in multiyear earn-out periods, where a company could outperform in some years and underperform in others. For example, if a company outperforms its metric in year one of an earn-out period, the excess can be structured to be carried forward. If the company does not achieve its year two financial performance metric, the excess can then be used to close the gap. A seller might then be eligible for the year two earn-out payment. A carry backward provision works in a similar fashion.
Regulating buyer and seller behaviour during the earn-out period
Buyers will be in control of a company after an acquisition and during the earn-out period. Sellers therefore often negotiate undertakings from buyers, which are designed to mitigate the risk of buyers’ taking actions that could affect the earn-out. Such actions might include decisions to make heavy investments in business expansion or plants and equipment, or in sales or hires. Also, if sellers do not have the benefit of protective undertakings, buyers may, as they are so entitled, emphasise aspects of the company’s business, such as sales categories or product categories, which could affect the earn-out.
Buyers’ undertakings to sellers have to be balanced against their freedom, as a company’s new owner, to operate it.
It is vital to be as specific as possible in designing undertakings or restrictions for buyers or sellers in an earn-out and, where relevant, setting objective measures that can be relied on with certainty. This will be influenced, amongst other things, by whether sellers remain involved in the business of the company being sold.
Sellers who are no longer involved with the company
Sellers may agree to an earn-out as part of the purchase price but do not wish to remain involved in the business of the company they are selling. Such sellers will likely need protection to ensure that buyers do not unfairly jeopardise the earn-out after taking control of the company. Two examples illustrate the significance of precision in designing buyer obligations to sellers.
The first example is the UK case of Porton Capital Technology Funds & Ors v 3M UK Holdings Ltd & Anor  EWHC 2895.
In this case, the sellers asserted that the buyer had breached undertakings to the sellers to, amongst other things, “diligently seek” regulatory approval for agreed products in certain markets, as well as “actively market” the products in these markets. The High Court of Justice of England and Wales disagreed and held that the buyer had satisfied both undertakings.
On the obligation to “diligently seek” regulatory approval, the court held that the word “diligently” meant “with reasonable application, industry and perseverance.” This concept, however, did not involve any obligation on the buyer to employ “any standard of care.” If the sellers had negotiated a standard of care, and this had been stated and defined in the agreement, they would have been better protected. The outcome of the dispute may have been different.
Also, the term “actively market” was not defined in the acquisition agreement, and the buyer benefitted from this ambiguity. The sellers could have negotiated for the expansion of the concept to include detailed activities that needed to be carried out and related deadlines, minimum marketing expenditure, etc. Parties could then have relied with confidence on specific requirements.
The second example is the U.S. case of Winshall v. Viacom International Inc., 76 A.3d 808 (Del. 2013).
In this case, the merger agreement did not contain a specified obligation on the parties to conduct business after the merger so as to ensure or maximise earn-out payments. The sellers asserted that this obligation fell under an “implied covenant of good faith and fair dealing” in Delaware law and wanted it to be enforced against the buyer. The Delaware Court disagreed, holding that “the implied covenant is not a license to rewrite contractual language just because the plaintiff failed to negotiate for protections that, in hindsight, would have made the contract a better deal.”
Sellers who remain involved with the company
Sellers may agree to an earn-out as part of the purchase price and also to remain involved in the business of the company they are selling. Such sellers will likely need protection to ensure that buyers will not unfairly jeopardise the earn-out by restricting the sellers’ ability to work toward maximising it.
There are a number of ways to address this. One way is for the sellers to negotiate the buyers’ undertakings to provide specified levels of support to the company during the earn-out period. This can be via marketing support or working capital injections. Another way is for sellers to retain veto rights over specified matters, which could affect the earn-out being achieved.
By contrast, buyers will likely need protection against sellers taking short-term actions to maximise the earn-out amount, but which could be detrimental to the company in the long term. One way to address this is to negotiate a longer earn-out period.
How earn-out disputes can be resolved
Two dispute resolution mechanisms are often used in acquisition agreements with an earn-out component. It is worthwhile to understand how each mechanism works and when each mechanism will apply.
The first mechanism is expert determination where parties dispute the calculation of an earn-out payment. In such event, experts, such as chartered accountants, are appointed to make a determination, which will be final and binding on the parties.
The second mechanism is to resolve disputes via courts or arbitration. This covers aspects of acquisition agreements that do not deal with calculating earn-out payments. For example, if a buyer breaches an undertaking to provide agreed levels of support to the sellers during an earn-out period, such a dispute will be a matter for courts or arbitration, not expert determination.
The significance of this distinction is illustrated in the U.S. case of Fit Tech, Inc. v Bally Total Fitness Holding (374 F.3d 1 (1st Cir. 2004)).
In this case, the sellers contended that the buyer had made a series of wrongful acts, which in turn, affected the calculation of the earn-out amount. The United States Court of Appeals for the First Circuit grouped the wrongful acts into two categories. The first category was “accounting violations,” where the sellers maintained that the buyer had not followed applicable accounting principles in calculating earnings. The second category was “operating violations,” where the sellers contended that the buyer had directed telephone enquiries away from the company to the buyer’s other businesses.
The buyer tried to dismiss the complaint before the court, arguing that the acquisition agreement required claims to be submitted to binding alternative dispute resolution by the accountant. The court found that the acquisition agreement referred to the accountant for the resolution of only accounting issues and not operational disputes that affect the earn-out payment. Therefore, the court could consider the remaining misconduct charges relating to “operating violations.”
Earn-out mechanisms are useful tools in an acquisition and can help parties to reach agreement despite differences in opinion on a company’s profitability or future earnings prospects. However, sellers and buyers are likely to use these mechanisms to proper effect only with prudent structuring of how earn-outs are calculated and paid, how sellers and buyers should behave during the earn-out period and how disputes relating to the earn-out can be resolved. This will be a balancing act, and one for which professional legal, accounting and tax assistance is essential.