The Importance of Word Choice When Defining an Earn-Out Provision
October 21, 2024
“Words – so innocent and powerless as they are, as standing in a dictionary, how potent for good and evil they become in the hands of one who knows how to combine them.”
– Nathaniel Hawthorne
In M&A, structuring the financial terms of a deal can be complex, especially when buyer and seller expectations differ regarding the business’s future performance. A practical solution to bridge this gap could be the inclusion of an earn-out provision in the purchase agreement. This would allow part of the purchase price to be contingent upon the post-transaction performance of the business, aligning the interests of both parties. However, improperly documented or vaguely defined earn-out provisions can lead to disputes, misunderstandings, and even litigation.
An earn-out agreement links part of the seller’s compensation to the future performance of the business. A clear definition of the financial metrics that trigger the earn-out is essential. Common metrics include revenue, EBITDA (earnings before interest, taxes, depreciation, and amortization), or net income. For example, if the agreement simply states “profit growth” without specifying how profit is calculated, parties could interpret this differently. Even something as simple as “gross revenue” can cause confusion if there isn’t a detailed definition that defines whether it includes discounts and returns in accordance with US GAAP. Therefore, a well-documented earn-out provision should clearly define the financial benchmarks and provide a detailed example of how they will be calculated to avoid confusion.
The performance period over which the earn-out applies must be clearly defined. Typically, an earn-out provision covers one to three years after the closing date. Clearly stating the duration of the earn-out period ensures both parties understand when the performance evaluation will begin and end. Additionally, the timing of payments should be specified. Will the earn-out be paid annually, quarterly, or in a lump sum after the performance period? By establishing these specific timelines, the parties can manage expectations and avoid disagreements over when the seller is entitled to compensation.
The success of an earn-out often depends on the buyer’s post-acquisition management of the company. If the buyer significantly changes the company’s operations or critical strategies, it can adversely affect performance, thereby impacting the seller’s earn-out compensation. The purchase agreement should clearly outline any restrictions on the buyer’s ability to make material changes during the earn-out period. Alternatively, the agreement might specify that certain adjustments to operations are permissible, ensuring transparency in how the business is managed post-acquisition. While an earn-out theoretically aligns the buyer’s and the seller’s interests, if the buyer wants to make significant changes to extract savings from the business, an earn-out might limit that ability.
The accounting methods used to calculate the performance metrics should be explicitly stated. Differences in accounting policies or practices between the buyer and seller could result in dramatically different outcomes for the earn-out calculation. For example, if the buyer adopts an aggressive approach in expensing potential capital assets post-closing, it could reduce earnings, negatively impacting the seller’s earn-out compensation. Including a requirement for third-party reviews or agreeing on consistent accounting standards throughout the earn-out period can help mitigate these risks and ensure fairness.
Earn-outs can become a major source of conflict, particularly when the post-transaction performance does not meet expectations. By including a dispute resolution mechanism within the purchase agreement, both parties can reduce the risk of costly litigation. This could involve specifying a neutral third-party arbitrator, mediation procedures, or defining specific performance review processes that must occur before a dispute can be escalated.
Earn-out payments can have significant tax implications for both buyers and sellers. The purchase agreement should carefully document how the earn-out payments will be treated for tax purposes, including whether they will be considered part of the purchase price or compensation to the seller. Proper tax planning in advance can help minimize the overall tax burden for both parties.
Earn-outs can be effective in M&A transactions, providing a win-win scenario when structured correctly. However, poorly documented or ambiguously defined provisions can lead to confusion, disputes, and even failed transactions. To avoid these pitfalls, it is essential to clearly explain all relevant terms in the purchase agreement, including financial metrics, performance periods, management controls, and dispute resolution mechanisms. With careful planning and precise documentation, an earn-out can serve its purpose—helping bridge valuation gaps and aligning incentives between buyers and sellers.
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