Earn out or burn out? A pricing mechanism for future performance

In an M&A world of increasing complexity and risk, earn outs are no more typical in structure than the deal itself. With growing uncertainty around future performance of many businesses, deferring consideration in the form of an earn out until the situation is more settled has become a more attractive proposition to Buyers, and one which helps Sellers to secure the sale of the target business.

In a push to get the deal signed, parties can often overlook the complexities of an earn out mechanism and the potential pitfalls lurking in the attempt to codify accounting approaches for uncertain eventualities. In the current economic circumstances, the impact of any pitfalls is likely to be exacerbated, and the parties’ tolerance for agreeing and moving on reduced.

Below we share our thoughts on why parties use earn outs, the challenges of using a performance-based pricing mechanism and how the outcome can be made less prone to dispute.

Structure and rationale for earn outs

The structure of the earn out mechanism will vary considerably from deal to deal depending on the size and nature of the business being acquired, and the expectations of the parties. The target business may have one or multiple key performance indicators that need to be factored into the mechanism.

While we typically see the earn out period covering between one and three years’ post-completion, certain industries favour a longer period as a mechanism for retaining talent. However, the longer the earn out period the greater the risk to the Seller that Buyer’s behaviour will materially influence the business, and to the Buyer resulting from an inability to integrate fully the target business. Ultimately, the length of the earn out period should reflect the parties’ risk appetite and desire for deal closure and the objectives of the earn out itself.

We are seeing parties turning to future-based value mechanisms (like earn outs) to ease concerns about potential volatility in performance in the immediate future and to bridge valuation gaps between Buyers and Sellers. However, there are risks associated with any form of deferred consideration that have to be carefully managed to mitigate the chances of disputes post-deal. Much of the value in agreeing an earn out can be lost in a potentially acrimonious dispute resolution process.

Common challenges and pitfalls

Dealing with exceptional circumstances – we see many earn outs where the parties have not thought through how to deal with exceptional circumstances that may arise during the earn out period, and whether or not they should be excluded from the earn out metric. Dealing with known issues (such as ongoing litigation) can be challenging enough, but the real challenge comes when unexpected issues emerge during the earn out period that give rise to a financial effect.

Differences in measurement – if the SPA is not carefully drafted, issues can arise because of transitions between the Buyer’s accounting approach and that previously adopted by the Seller. While most SPAs take into account major changes in accounting policy, it is important to remember that accounting policies involving the exercise of management judgment can give rise to issues for the Seller once management’s loyalty transfers to the new owner on or before Closing.

Allocation of costs – if the target is joining a larger organisation, it may well benefit from synergies from shared services with its new corporate family. However, both Buyers and Sellers need clarity in the SPA on how the costs of shared services are to be treated. This applies just as much to additional compliance costs or other corporate central costs as it does to synergistic savings. The last thing a Seller wants is a target unexpectedly loaded down with management recharges in the earn out period.

Party behaviour – Whichever party is responsible for running the target company after Closing (it can be Buyer or Seller, depending on the circumstances) will always face the temptation to act so as to meet their own objectives around the earn out. For example, maximising the earn out through short-termism (for the Seller) or over-investment with a short term negative effect on profit to promote longer term future gains (for the Buyer). Protections put into the SPA for the non-managing party can be difficult and costly to enforce.

Commercial considerations – it is all too easy for parties in the heat of an earn out dispute to lose sight of the reason that they agreed an earn out in the first place. If the earn out is not achieving its commercial objectives, consider cutting a deal and moving on rather than being bound by it.

Practical tips for a robust mechanism

Prepare for the unexpected – as far as possible, have agreements in place for the more foreseeable issues that might arise, such as litigation.

Keep the commercial rationale in view – the parties will have had a commercial objective in signing the earn out. Keep that in mind when negotiating; the need to preserve a commercial relationship can encourage both sides to behave proportionately.

Keep the other party informed – perhaps even consider preparing accounts under the approach required by the earn out on a monthly or quarterly basis during the earn out period. This will allow the party that is not directly involved in managing the business to understand the business’ performance and how it is likely to relate to the earn out.

Maintain professional scepticism – both Buyer and Seller are ultimately concerned with their own best interests and as such will actively seek a commercially viable deal. Maintaining professional scepticism throughout this process, given the direct value at stake to both parties, is strongly advised.

Be specific – there is scope for interpretation and the application of judgment in calculating the underlying metric(s) of most earn out arrangements. By introducing specific drafting into the SPA which clearly sets out the basis on which these metrics are to be calculated, the parties’ expectations can be better aligned and the risk of a dispute reduced.

We are happy to assist you, either with advice on resolving a contentious matter at the negotiation phase, or with navigating the expert determination process. If we can help, please get in touch. Please contact Claire Jolly, Philip de Voil or Matt Odams.