In an earn out a seller will receive part of the purchase price as deferred consideration, subject to a target being achieved by the business post completion. The target could be financial (turnover or profit levels are common) or performance based (the delivery of a specified project by the business).
Whilst earn outs have the potential to be “win win”, there is often a dynamic tension during the earn out period between the business objectives of the buyer and the financial objectives of the seller. Agreeing the detail of an earn out can thus be difficult including in relation to the following issues:
1. Identifying the performance target – establishing the agreed earn out target(s) is key. These should be clear and, crucially, measurable, to avoid misunderstandings between the parties.
2. Clarifying the earn out formula – the formula for calculating the earn out should be sufficiently complex to factor in partial performance against the target. It should also provide a mechanic to act as a disincentive against a seller leaving the business prematurely. “Good leaver/bad leaver” terms may be required although care should be taken to ensure they do not prejudice the seller’s favourable capital gains treatment.
3. Control of the acquired business – the seller will want as much operational control as possible over the business to ensure a level playing field and so maximise his earn out. Conversely the buyer will generally want to achieve synergies between the acquired business and the rest of its group. Therein lies the inherent tension and the basis for often much negotiation as to how the business is to be run post completion.
4. Foreseeable events – great care should be taken to consider the effect of any foreseeable events and, so far as possible, any unanticipated events, that could impact on the earn out performance.
5. Acting in good faith – restrictions should be contained in the earn out to promote the parties acting in “good faith” to avoid any manipulation of the earn out results.
Experience shows that sellers at the outset tend to focus on the first two issues which are more tangible but do not pay enough attention to the more intangible but still crucial final three issues.
The recent High Court decision in Porton Capital Technology Funds and others –v- 3M Holdings and others highlights well the inherent risks associated with earn outs and the perils when things do not go to plan of failing to deal in the agreement with these intangible issues. As ever, the devil is in the detail and there is no substitute for good advice.