Selling or acquiring a company with an earn-out arrangement? Here's how it works!
The earn-out arrangement is a commonly used solution for business acquisitions and -to sell, especially when buyer and seller disagree on the company's value. This difference in perspective can lead to impasses in negotiations, but the earn-out arrangement offers a way to complete the transaction. By making a portion of the sales price contingent on the company's future performance, both parties can align their interests. In this article, we explain what an earn-out arrangement is, how it works, and the advantages and disadvantages for both buyer and seller.
Why consider an earn-out arrangement?
1. Bridge between buyer and seller
The earn-out arrangement offers a solution when the buyer and seller have different views on the future value of the company. It makes the sales price contingent on future performance, giving the seller the opportunity to receive more if the company's performance exceeds expectations.
2. Flexibility and risk management
For the buyer, the arrangement offers flexibility by reducing risk. They don't pay the full amount upfront, but only a portion of the purchase price, depending on the company's future performance. This allows them to spread the payment over time, which is especially useful with limited financing.
3. Increase in the sales price
For the seller, an earn-out offers the opportunity to increase the sales price, provided the agreed-upon performance criteria are met. The seller often remains involved with the company and can influence its performance, allowing them to capture more value.
How the earn-out scheme works
An earn-out arrangement consists of two components: a fixed portion and a variable portion. The fixed portion of the purchase price is paid upon transfer of the business, while the variable portion is dependent on achieving predetermined performance targets. These performance targets can be financial, such as revenue or profit targets, or non-financial, such as launching a new product or achieving specific customer goals.
Fixed part
: This is the portion of the acquisition price that is paid immediately upon transfer. It provides the buyer with certainty regarding the initial costs, while the seller receives a portion of the sales price upfront.
Variable part
: This portion depends on the company's future performance. Its size is determined by achieving predetermined milestones, which can be either financial (such as profit or revenue growth) or non-financial (such as product launches or customer targets). The seller receives the variable portion if the agreed-upon targets are met.
Step-by-step plan for a successful earn-out arrangement
1. Define clear performance criteria
It's essential to agree on clear and achievable performance criteria. This can relate to financial results like turnover or profit, but also to non-financial goals like customer satisfaction or product development.
2. Determine the term of the earn-out
The term of the earn-out arrangement must be realistic. Typically, the arrangement is agreed upon for a period of one to three years, but this can vary depending on the sector and the company.
3. Agree on who has control
It's important to clearly agree in advance on who is responsible for decisions that affect performance. This prevents conflicts between buyer and seller regarding business operations during the earn-out period.
4. Establish a dispute procedure
Because there may be room for interpretation, it is advisable to establish a dispute procedure in the event of a dispute arising regarding the implementation of the earn-out arrangement.
5. Document the arrangement in the LOI
The earn-out arrangement is often recorded in the Letter of Intent (LOI), or the letter of intent. This provides clarity for both parties and ensures that the arrangement is properly defined before the final sales agreement is drawn up.
Benefits of the earn-out arrangement
Copper
Reduced risk
: The buyer initially pays a lower amount, and the final price depends on the company's future performance. This reduces the risk that the company won't deliver the expected value, because the payment is spread over time.
Flexibility
: By spreading the payment, the buyer gets more room in the financing. This can be especially beneficial when resources are limited or when the acquisition phased must take place.
Seller
Maximization of the sales price
: If the agreed-upon performance is achieved, the seller can increase the final selling price. This allows the seller to generate more profit from the sale than the initial offer, depending on the company's performance.
Commitment to the future
: Often the seller remains actively involved in the company, which gives him the opportunity to contribute to the realization of the performance and thus achieve his earn-out.
Disadvantages of the earn-out arrangement
Copper
Higher final costs
: If the company performs well and achieves its objectives, the buyer may ultimately pay a higher price than the original offer. This can increase the total cost of the acquisition.
Complexity
: Drafting an earn-out agreement can be complex, especially if the performance criteria are vague or difficult to measure. This can lead to uncertainty or misunderstandings between buyer and seller.
Seller
Risk of not achieving the earn-out
: The seller runs the risk that the agreed-upon performance isn't achieved, resulting in less than expected. This can be especially problematic if the company's performance is beyond their control.
Insecurity
: Because the earn-out depends on the company's future performance, there is always an element of uncertainty. Market changes, customer relationships, or the relationship with the buyer can affect the outcome, potentially causing the seller to miss out on the earn-out.
Tips for drawing up an earn-out arrangement
Creating an earn-out agreement requires careful planning and clear agreements. Here are some important tips:
Be clear about the performance criteria
: Make sure the performance criteria are measurable and achievable. This prevents confusion and conflict in the future.
Set the term
: Set a clear term for the earn-out arrangement. This makes it easier to monitor performance and keeps the arrangement transparent.
Be transparent about business operations
: Make sure both parties agree on who will be in charge of the business operations during the earn-out period. This prevents misunderstandings regarding implementation.
Establish a dispute procedure
: Because earn-out arrangements often lead to differences in interpretation, it is important to establish a dispute procedure to resolve conflicts.
Why choose Match Plan?
At Match Plan, we understand that an earn-out arrangement can be a powerful tool, but it can also be complex. Our experts can help you with:
- Establishing clear and achievable performance criteria.
- Negotiating the terms of the earn-out arrangement.
- Guiding the process from start to finish to achieve a fair and successful settlement.
- Ensuring a sound legal and fiscal structure.
Our experienced advisors ensure that the earn-out arrangement is legally sound, so you can rely on clear and transparent agreements. This helps prevent conflicts and provides a solid foundation for the future. Contact us and discover how we can help you optimally utilize an earn-out arrangement for your business acquisition.
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