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As purchasers take a more cautious approach to M&A in the current economic climate, it's no surprise that we are seeing an increased use of earn-out provisions within deals. 

Earn-outs can be useful, especially during periods of heightened market uncertainty.  They can bridge a gap between a purchaser and seller as to the true value of a target business, having regard to possible future performance of the business. 

As the popularity of earn-outs continues to grow, so do the complexities.  As is often the case with other legal drafting, the more detailed and layered the earn-out, the greater the risk it becomes overthought and overcomplicated, leading to higher costs, potential for disputes and enforcement issues. 

This article provides brief thoughts on the perils of an overcomplicated earn-out, and suggestions as to when earn-outs may be used inappropriately. 

Just briefly going back to basics, an earn-out is a mechanism whereby on the sale and purchase of a company's shares or its business and assets, the purchase price is partially determined by reference to the future performance of the target company. 

At face value, a well-drafted, clear, and simple earn-out provision can be beneficial to both purchaser and seller.  From a seller's perspective, by including an earn-out, a purchaser may be prepared to pay a higher purchase price conditional on future profitability.  From a purchaser's perspective, an earn-out ensures that part of the purchase price is directly linked to actual future performance of the target business, which can help to remove a layer of post-acquisition uncertainty and risk from the deal.

In our experience, there are some key drivers that lead to an earn-out provision being overcomplicated.  There is something to be said for applying the KISS principle – 'Keep it Simple Stupid' – a mantra that should be kept front of mind when drafting and negotiating an earn-out provision. 

Three things to avoid when negotiating an earn-out:   

  • Use of earn-out as a retention tool:  Some purchasers feel compelled to use an earn-out provision to retain vendors who are also key employees for a period of time post completion.  Using an earn-out as a retention tool is dangerous.  The objective of the earn-out should be to help bridge a perceived value gap in a fair way, not to retain or reward talent within the business.  If the parties' intentions are to retain key talent in the target company or to punish those who do not remain in the business, an earn-out provision is not the right mechanism.  The blurring of the line between on the one hand 'vendors' (ultimately the shareholders of the vendor), and on the other hand 'key talent' creates a range of issues.  Purchasers should remember that an earn-out is paid to shareholders of a business as part consideration for selling that business.  Tying in or motivating key talent going forward is generally not the focus.  Importantly, when earn-out payments are linked to individuals remaining within the business, the receipt of an earn-out payment is likely to be taxable in the hands of the recipient. 
  • Multi-year targets:  Multi-year arrangements can also result in an overcomplicated earn-out.  A lengthy earn-out timeline can open the floodgates for endless scenarios needing to be considered and factored in, including key employees leaving, adjustments to reflect post completion restructures, consequences of purchaser led initiatives or changes, and the treatment of part periods of financial years.  The longer the earn-out timeline, the more complex it becomes, with greater room for dispute.  An earn-out over a shortish period (and not more than three years), with more simple and clearly defined targets, can provide the most practical mechanism for bridging the gap between value and uncertainty of future earnings.  Where earn-outs run for several years with varying (and perhaps increasing) targets each year, parties also need to consider whether 'unders and overs' result in adjustments being carried forward.  Creating truly fair targets and a fair measurement system gets harder the longer the earn-out period runs.
  • Keep the earn-out in perspective to the deal size:  A key factor for negotiating parties to bear in mind is making sure they don't allow the earn-out to become the focus of the entire transaction.  If the transacting parties want to include an earn-out mechanism, it should be allocated and require an appropriate amount of time, effort and budget relative to the size of the potential earn-out in the context of the deal.  As complex earn-outs have emerged in the markets, and although lawyers might enjoy drafting them, negotiating parties should still be mindful of spending too much time (and legal fees) on an overcomplicated provision which, by the end of the negotiation becomes a 10 pager that is difficult to manage in practice. 

Earn-outs can work extremely well – more often when they are simple, straightforward, and easy to apply.  It always pays to take a step back and ask yourself whether an earn-out is appropriate in light of the deal, or if you are overcomplicating negotiations for the wrong reasons. 

This article was written by David Thomson (partner) and Victoria Mills (solicitor).