Summary
- Earn-outs link part of a business sale price to post-completion performance, helping buyers and sellers bridge valuation gaps when they cannot agree on a fixed price upfront.
- The key risks include disputes over performance measurement, buyer conduct during the earn-out period, and how calculations are prepared and reviewed.
- Clear drafting, early negotiation of earn-out terms, and specialist legal and tax advice are essential to protect a seller’s position and reduce the risk of disputes.
- This article is a plain-English guide to earn-out clauses in share purchase agreements for Australian business owners involved in buying or selling a company.
- It has been prepared by LegalVision, a commercial law firm that specialises in advising clients on business sales and acquisitions.
Tips for Businesses
Agree earn-out principles at heads of terms stage, before drafting begins. Define performance metrics precisely and specify which accounting standards apply. Include seller protections limiting how the buyer can manage the business during the earn-out period. Seek legal and tax advice early – earn-out structures have significant implications for both.
If you are selling a company then it is vital for you to agree on and clearly document the transaction’s payment terms. Businesses might prefer to agree on the purchase price before signing the agreement for clarity. However, a fixed price may not fully reflect future risks or uncertainty about the business’s value. This article explores earn-out clauses in the context of share purchase deals.
What Is an Earn-Out?
Put simply, an earn-out is a part of the share purchase agreement (SPA) where some of the price is paid only if the business meets certain goals rather than paying everything at once.
The earn-out is often based on the company’s financial results over a set period after the sale – often one to three years. While they are often based on company profits, earn-outs can also be linked to the following:
- sales;
- net assets;
- earnings before interest, taxes, depreciation and amortisation (EBITDA); or
- even product sales or growth.
Some earn-outs pay a percentage of profits or revenue during the earn-out period. Others only pay if certain performance targets are met. If the company does not reach those targets, the buyer may not have to pay, or the payment may be reduced.
Why Consider Using an Earn-Out?
More corporate deals now include structures where part of the price is paid later – such as earn-outs or deferred payments. There are several reasons to use earn-outs.
One common reason is to close the gap between what buyers and sellers think the business is worth. The parties can use earn-outs when they cannot agree on the value of the business at the time of sale. Buyers might lower the price because they are unsure about future profits, while sellers may think the business is worth more because of expected growth. An earn-out lets them move forward with the sale.
Earn-outs can also help keep key people (e.g. founders or managers) involved after the sale, which can be important for the business’ success. This can be common if sellers remain employed or involved in the business during the earn-out period. Their experience and ongoing work can be important for reaching performance targets.
Although earn-outs can be an effective tool, it is important to understand that they are not appropriate in all circumstances. They can introduce more complexity and the potential for disagreement between the parties.
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What Risks Should Parties Consider About Earn-Outs?
Earn-outs can work well, but can also bring about risks and challenges.
Sellers will not get a clean break, and the final amount depends on how the business performs, what the buyer does, and market conditions after the sale.
Disputes can arise with earn-outs, especially over:
- how performance is measured;
- how the business is managed during the earn-out; and
- how calculations are made.
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Key Drafting Tips for Earn-Outs
The SPA should clearly state how the business will be managed during the earn-out and how the earn-out will work.
Negotiating Earn-Outs
Earn-out provisions in the SPA should not be left until the end of negotiations. Earn-outs are often complex, require extra documentation, and can take time to agree. This is especially where:
- accounting mechanics;
- performance metrics; and
- buyer conduct protections all need agreement.
In practice, the key commercial terms of an earn-out are often agreed at the heads of terms stage.
Key Issues to Consider for an Earn-Out
The rules for an earn-out are usually set out in a separate schedule to the SPA. Though earn-out rules vary by transaction, common themes include:
- the performance measure;
- earn-out duration;
- payment timing;
- dispute resolution;
- seller rights; and
- any restrictions on company actions that could affect the earn-out.
The relevant schedule should cover how the earn-out payments will be satisfied, including whether the buyer will pay them in cash or by non-cash consideration.
The parties should also consider the extent to which the buyer may integrate the target business with its existing group during the earn-out period. Sellers may also need to consider whether they require security for the buyer’s obligation to pay earn-out consideration.
Both buyer and seller often want the business to do well during the earn-out, and if the schedule includes agreed ways of working together effectively, it can help align incentives and support getting the most from the earn-out.
Calculation Process
The agreement should clearly set out how to measure the company’s performance and calculate the earn-out. This includes which accounts to use, what accounting rules apply, and the schedule for preparing and reviewing the numbers.
Parties may wish to refer any earn-out disputes to an independent expert to resolve any technical questions. The agreement should set out what the expert will do, the steps to follow, and how costs will be shared.
Considering Tax Input and Legal Advice
There are important tax and legal issues to consider with earn-outs.
An earn-out means part of the sale price is based on the company’s profits or performance after the sale. How the earn-out is taxed depends on factors such as how it is set up and who gets the payments.
Both sides to a transaction should seek appropriate legal, tax, and accounting advice when planning an earn-out. This can help mitigate legal and tax risks and ensure the parties are comfortable that the earn-out arrangement reflects their commercial agreement.
Key Takeaways
Earn-outs can help bridge valuation gaps in a corporate sale and deliver value, but can also add complexity and lead to disputes. To protect value and ensure an earn-out works as planned, it is important to agree on earn-out principles, early draft earn-out terms carefully and seek vital legal and tax advice on how to structure the earn-out provisions and reduce risk.
LegalVision provides ongoing legal support for businesses through our fixed-fee legal membership. Our experienced business sale and purchase lawyers help businesses manage contracts, employment law, disputes, intellectual property, and more, with unlimited access to specialist lawyers for a fixed monthly fee. To learn more about LegalVision’s legal membership, call 0808 196 8584 or visit our membership page.
Frequently Asked Questions
What Is an Earn-Out Clause?
An earn-out clause is essentially a provision in a business purchase agreement under which part of the purchase price is payable only if the business achieves agreed performance targets after completion.
Should Sellers Take Legal Advice on an Earn-Out?
Sellers should take legal advice before they agree on the earn-out structure – both when negotiating and finalising the heads of terms and share purchase agreement. This is to ensure the earn-out terms properly reflect the agreed commercial position and protect themselves from legal risk. Tax advice is also critical.
Who prepares the earn-out accounts?
Typically the buyer prepares the earn-out accounts, but the SPA should specify the process, applicable accounting standards, and the seller’s rights to review and challenge the figures.
What happens if the parties dispute the earn-out calculation?
The SPA can refer calculation disputes to an independent expert, whose determination is usually binding. The agreement should specify the expert’s scope, process, and how costs are allocated.
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