Earn-Outs

1. Introduction

In M&A transactions, both buyers and sellers aim to maximize their value but often have differing perspectives on the business' value and potential future performance. Sellers are typically more optimistic about the business' growth potential, while buyers prefer not to pay a price based on projected results. To bridge this gap, the consideration for the acquired business can be split over time, with deferred payments contingent on certain conditions being met. This is commonly referred to as an "earn-out."

2. What is an earn-out?

An earn-out is a contractual payment arrangement between the buyer and the seller, where part of the purchase price is conditional on the future performance of the business. Typically, the earn-out is based on metrics such as EBITDA (earnings before interest, taxes, depreciation, and amortization), gross revenues, or gross profits. The seller receives the earn-out payment if the acquired business meets certain agreed-upon milestones after the acquisition is finalized.

From the buyer’s perspective, the earn-out ensures that the total purchase price is based on actual performance rather than projected performance. It also allows the buyer to reduce the upfront investment burden and spread the cost over several payments. From the seller’s perspective, the earn-out provides an opportunity to benefit from any post-transaction growth of the acquired business, which can then be factored into the total purchase price.

Thus, the earn-out reduces the buyer’s risk of overpaying for the business based on assumptions that do not materialize, while offering the seller a chance to reap the benefits of strong post-transaction performance.

3. Sweat equity and sweet equity in earn-outs

Sweat equity refers to the value added to a business through the hard work, expertise, and dedication of individuals, rather than through financial investment. In the context of earn-outs, sweat equity becomes particularly relevant when sellers or key employees continue to be actively involved in the business post-transaction. Their ongoing efforts can be crucial in achieving the performance targets set for earn-out payments. Sellers who contribute sweat equity often bring valuable insights and operational expertise that can drive the business towards meeting its earn-out goals. Their intimate knowledge of the business operations, customer relationships, and market dynamics can be leveraged to enhance performance metrics such as EBITDA, gross revenues, or profits. To ensure that sellers remain motivated to contribute their sweat equity, earn-out agreements can include provisions that reward their efforts. This might involve additional compensation or bonuses tied to the achievement of specific milestones, thereby aligning their interests with the success of the business. While sweat equity can be a powerful driver of business success, it also presents challenges. Sellers may need clear guidelines and defined roles to prevent conflicts with new management or ownership. Additionally, the value of sweat equity should be recognized in the earn-out structure to ensure fair compensation for the seller's continued contributions.

Sweet equity refers to the financial incentives or benefits provided to key stakeholders, such as management or employees, to align their interests with the success of the business. In earn-out arrangements, sweet equity can be a strategic tool to motivate the management team to achieve the performance metrics required for earn-out payments. By offering sweet equity, buyers can ensure that the management team is invested in the business's success. This can include share options, profit-sharing arrangements, or bonuses tied to the achievement of earn-out targets. Such incentives encourage management to focus on driving growth and meeting performance milestones. Sweet equity can lead to improved business performance by fostering a sense of ownership and accountability among key stakeholders. When management has a financial stake in the outcome, they are more likely to implement strategies that enhance operational efficiency, customer satisfaction, and revenue growth. The structure of sweet equity should be carefully designed to align with the earn-out objectives. This involves setting clear performance metrics, timelines, and conditions for receiving sweet equity benefits. Additionally, it is important to ensure that sweet equity does not dilute the value of the business or create conflicts with other stakeholders. While sweet equity can be effective in motivating stakeholders, it also carries risks. Misalignment of incentives, unrealistic performance targets, or lack of transparency can lead to disputes or dissatisfaction. Therefore, it is crucial to establish clear terms and communicate expectations to all parties involved.

Incorporating elements of sweat equity and sweet equity into earn-out arrangements can significantly enhance their effectiveness. By recognizing the value of non-monetary contributions and aligning financial incentives with business success, buyers and sellers can create a collaborative environment that drives the business towards achieving its desired milestones. This approach not only facilitates smoother transactions but also ensures that all parties benefit from the continued success of the acquired business.

4. Avoiding the pitfalls

Structuring an earn-out can be complex, requiring detailed agreements on performance metrics, calculation methods, and timelines. Disputes concerning earn-outs frequently emerge due to differing interpretations of the relevant metrics for earn-out payments or allegations of manipulations that violate earn-out protections. Typically, these disputes center on what should be included or excluded in the earn-out calculation, the method for calculating revenues or costs, and the handling of any structural changes post-transaction.

Manipulation disputes often involve claims that the seller intentionally underspent to inflate short-term results, or that the buyer managed the business in a manner that negatively affected the results, thereby reducing or preventing the earn-out payment.

Many disputes can be avoided by including clear and unambiguous provisions in the share purchase agreement (SPA). For instance, tying the earn-out to net profit without defining what constitutes net profit can lead to disagreements when it is time for the earn-out to be paid. By explicitly defining what should and should not be included in the calculations, providing a clear reference point for measuring results, and establishing clear policies for managing areas open to interpretation, the risk of disputes can be significantly reduced. In addition, the SPA should outline provisions which determine the parties conduct during the earn-out period. The seller will likely request that the buyer continue to operate the business in the ordinary course, while the buyer will seek the flexibility to change business operations as needed. At a minimum, the parties will typically agree to operate in good faith and fair dealing, and to use ‘commercially reasonable efforts’ to prevent actions that may result in the reduction of the earn-out payments, and to conduct business in a manner that does not jeopardize the earn-out.

Another important aspect of safeguarding earn-outs is the practice of isolating specific parts of the business to ensure that earn-out calculations are not influenced by unrelated business activities or changes to the business structure – known as ring-fencing. This approach aims to protect particular financial metrics to ensure that they accurately reflect the business' performance post-transaction and are not negatively impacted by, or obscured within, other aspects of the business and thereby preventing the earn-out milestone from being achieved. 

5. Tax implications of an earn-out

The structure and characterization of an earn-out plays a crucial role in determining the tax implications following the transaction. Typically, an earn-out is treated as part of the purchase price for tax purposes. However, if the seller continues to provide services to the company, the earn-out may be classified as compensation for those services. From the seller’s perspective, it is generally preferable for the earn-out to be treated as part of the purchase price, as this allows for taxation at the lower capital gains tax rate. Conversely, the buyer might favor the earn-out being treated as compensation, as this allows the company to deduct the payment as an employer-related cost, which should not be the case for payments considered part of the purchase price. If the payments are considered part of the purchase price, it should instead be considered when calculating future capital gains or losses pertaining to the acquired shares. If the earn-out is treated as compensation, it would additionally be carefully considered from the buyer whether the payments entails any obligations pertaining to employer-related costs (e.g. social security, pensions, etc.).

Several factors collectively influence the tax treatment of the earn-out, affecting both the seller's tax liabilities and the buyer's tax deductions. These factors include whether the seller must perform services to receive the earn-out payment and, if so, whether the seller is receiving separate reasonable compensation for such services; whether the seller must be employed throughout the entire earn-out period or if the earn-out is paid even if the seller is terminated.

To mitigate the risk of the earn-out being classified in an undesired way, the SPA should be drafted with a clear goal in mind. This involves explicitly defining the nature of the earn-out payments and the conditions under which they are made. Clear language should be used to specify whether the earn-out is part of the purchase price or compensation for services rendered. Additionally, the SPA should outline the responsibilities and expectations of both parties during the earn-out period to avoid any ambiguity that could lead to unfavorable tax treatment.

In conclusion, earn-outs are a valuable tool in M&A transactions, providing a balanced approach to addressing differing valuations and future performance expectations between buyers and sellers. By structuring earn-outs with clear, unambiguous terms and carefully considering the tax implications, both parties can protect their interests and minimize potential disputes. When executed effectively, earn-outs not only facilitate smoother transactions but also align incentives, ensuring that both buyers and sellers benefit from the continued success of the acquired business.

6. Conclusion

Earn-outs are a strategic tool in M&A transactions that help bridge the gap between differing valuations and future performance expectations of buyers and sellers. By tying part of the purchase price to the business's future performance, earn-outs align the interests of both parties, reducing the risk of overpayment for buyers and offering sellers a chance to benefit from post-transaction growth.

The success of earn-outs depends on clear and precise structuring within the share purchase agreement (SPA). This includes defining performance metrics, calculation methods, and timelines to minimize disputes. Incorporating sweat equity and sweet equity can further enhance earn-outs by motivating key stakeholders to achieve performance targets through non-monetary contributions and financial incentives.

Tax implications are also crucial, as the classification of earn-out payments affects tax liabilities and deductions. Clear language in the SPA should define whether payments are part of the purchase price or compensation, ensuring favorable tax treatment.

When earn-outs are well-structured, they facilitate smoother transactions and align incentives, ensuring both buyers and sellers benefit from the business's continued success. This collaborative approach fosters growth and enhances the overall value of the transaction.

Author: Martin Tenselius, Director Legal M&A.