Because of the extremely quick and sharp economic downturn caused by the COVID-19 pandemic, business valuations have changed as the future becomes less predictable. Given the economic uncertainty and timing of recovery prospects, both potential sellers and buyers may struggle to define enterprise value and agree on a purchase price. To address the uncertain valuations and forecasting difficulties, we expect to see an increase in the use of earn-outs and other forms of contingent purchase price consideration in M&A transactions. This article summarizes the meaning and purpose of earn-outs and then highlights issues that a buyer and seller typically encounter when negotiating and managing the contingent portion of transactions.
Earn-Outs: Definition and Purpose
While most sellers prefer to receive 100% of the purchase price at closing, in some cases – and likely more often during the pandemic and the early recovery period – sellers and buyers are unable to agree on a set purchase price to be paid at closing. Buyers tend to be skeptical of seller’s or management’s projections and will likely not agree to value the business based on its pre-pandemic performance and financials. At the same time, an otherwise willing seller may be unwilling to sell at a valuation that has been reduced because of the pandemic uncertainty. In such a case, the parties may agree to use an earn-out or contingent consideration to bridge the valuation gap. An earn-out is a tool that entitles a seller to receive future additional purchase price if the target business achieves certain performance goals. In this way, the seller essentially “bets” on the future performance of the business, and, if the seller is correct, then it would be entitled to additional consideration. Conversely, if the buyer’s skepticism turns out to be well founded, then the buyer would not be obligated to pay the additional consideration. A buyer may also want to defer a portion of the purchase price consideration to ensure that the seller still has “skin in the game” post-closing and will work to achieve the future business goals the buyer has for the acquired business, such as incentivizing employees and/or the seller to continue employment and to drive revenue and other financial metrics. The earn-out becomes a “proxy” for the future value of the acquired business. That said, identifying the right amount, timing, and metrics to accurately predict the future valuation is tricky.
Earn-outs can be very complex. They can, and often do, lead to litigation because of that complexity. As a result, great care needs to go into any earn-out provision.
Issues That Arise in Connection with Earn-Outs
The seller often bears significant risk with respect to an earn-out, both because of the inherent uncertainty of future performance and because it is nearly certain that even if the seller remains involved in the management post-closing, a business will be operated differently under a new owner. Linking seller’s entitlement to an earn-out based upon performance that seller cannot control naturally creates challenges. The buyer’s desire to freely operate the business it just purchased must be balanced with the seller’s desire to control the ability of the business to meet the earn-out objectives. While each situation poses its own unique questions, when an earn-out arises in negotiations, sellers and buyers should keep in mind the following issues.
Performance Metrics and Calculation
The central component of an earn-out is the performance metrics that will be used to determine if the seller has achieved specified goals. Metrics can be financial, such as achieving a certain EBITDA, net income, or revenue target, or non-financial, such as securing regulatory approval for a new drug, retention of a significant portion of the acquired company’s employees, completion of an ongoing capital improvement at or below budget, or being awarded a follow-on or new contract.
1. Financial Metrics
If the metrics are finance-based, the parties need to consider how those metrics will be calculated. As a threshold matter, the parties must identify what metric will be the best “proxy” for future success of the acquired business. There are many possible options, but the most typical financial metrics are EBITDA, gross revenue, or net income. Each of these metrics poses challenges, and none is perfect. Net income can be a more useful proxy for the actual value of the acquired business to the buyer than gross revenue, in that it reflects the true “bottom line.” On the flip side, a seller may be more comfortable with gross revenue than with net income because the seller will argue that it can control the gross amount it receives from its customers for the goods and services it performed, but it cannot control or predict how the costs of the business will change once it is owned by the buyer or how the buyer will calculate net revenue. Buyers are less comfortable with gross revenue targets in that they may worry that the management team that stands to benefit if the earn-out metric is achieved may be motivated to accept low-margin projects just to drive up gross revenue. Similarly, while EBITDA may have been used by the buyer in its initial valuation, it might be a less preferred measure for a seller in the context of an earn-out. The same challenges that impact using net income, specifically the lack of seller control, may make it difficult to agree on a targeted EBITDA post-closing in the current environment. If EBITDA is used as a target and the acquired business has received a Paycheck Protection Program loan that might be forgiven post-closing, buyers should consider specifically excluding the forgiven loan amount from the calculation of “earnings” before calculating EBITDA. Regardless of the metric chosen, buyer’s accounting and financial teams should help craft specific definitions of even commonly used financial terms to be included in the purchase agreement to help minimize misunderstandings that might lead to future disputes.
Additional questions will arise during the negotiations, including what accounting standard will apply. For example, if the buyer uses IFRS, but the financials of the acquired business were based on GAAP, what standard should apply to the earn-out calculations? What if the acquired business was not fully GAAP-compliant, or if it is a carve-out transaction without its own historical stand-alone financials? The parties need to agree on the methodology and should take care to anticipate and address any ambiguity as to the calculation. To ensure a common agreement, parties should consider attaching an example calculation to the purchase and sale agreement.
2. Non-Financial Metrics
In many ways, it is much easier to determine whether non-financial metrics have been achieved. In addition, certain non-financial metrics directly relate to future earnings. For example, whether a key contract is renewed or awarded can be easily judged as being met or not met, but if the contract is renewed or awarded, it is likely to have a positive impact on future revenue. Given that, it is often preferable to combine financial and non-financial metrics in a single earn-out structure. For example, if $20 million of the purchase price is contingent on future earnings, the parties should consider whether to include a financial metric that will act as the sole proxy for the anticipated future earnings, or if it would perhaps be easier to administer (and negotiate) if a portion of the contingent consideration was payable upon award of the anticipated key contract. The driving rule should be to keep the provision as simple as possible.
Disputes can still arise over non-financial metrics. For example, the seller may be concerned that the buyer will not negotiate the key contract in good faith, or, because the buyer’s overhead is more significant than the seller’s, the labor rates included in the post-closing proposal are likely to be higher than seller would have included pre-acquisition, so the contract may not be awarded. Of course, the buyer will worry that the seller may include unrealistic rates or discounts just to get the award. Likewise, metrics such as receiving regulatory approval might also be fraught with potential for dispute. Sellers may wish to continue to control the regulatory process and continue to use its own legal and business team, while the buyer would prefer that its advisors control or at least be involved.
Many transactions, particularly for technology companies, include workforce retention metrics. Buyers understand that if key managers or engineers resign following the closing, the value of the acquired business is lessened by the loss of customer relations, as well as the trade secrets and skills known to those employees. While accepting this premise, sellers may worry that the employees may leave as a result of a clash with the buyer’s culture and due to no fault of the sellers. Sellers may ask that buyer commit to certain post-closing obligations, that are important to employee retention. Covenants related to “culture” are difficult to define and draft. In some cases, the parties may just agree on a certain expected attrition rate to avoid disputes and to give the seller “credit” for employees who leave due to no fault of its own, or even for employees who are terminated by the buyer without cause.
Another metric that is commonly used is headcount growth, meaning that the seller may be entitled to earn contingent consideration if it is able to recruit employees to grow the business. Even this worthy goal can lead to negotiation issues between buyers and sellers, as buyers may be concerned that sellers may lower recruiting standards or hire new employees without regard to need in order to achieve growth metrics. In such cases, the parties may agree to a “recruiting committee” comprising the buyer and representatives of the sellers to agree on recruiting goals and processes. Another option might be to combine headcount growth metrics with utilization metrics.
Additional Considerations
Even once the threshold questions have been negotiated, there are a number of other provisions to consider and negotiate. Those include:
- Length of Earn-out Period – The parties will need to agree on the length of the earn-out period. In general, sellers would prefer to have the earn-out period to be shorter, while the buyer will want to ensure that the earn-out period is long enough to fully measure the post-closing performance of the acquired business.
- Payment Structure – Earn-outs can be all or nothing (i.e., seller is paid only if it achieves a certain metric) or they can be based on a sliding scale. In the sliding scale scenario, for example, seller is paid $X if it achieves revenue in year 1 within a certain range or $Y if it achieves revenue in year 1 within a different range. Sellers typically prefer the sliding-scale approach. Sellers may also negotiate the right to earn a “catch-up” payment if the metrics for one year are not met, but in the next year, the seller is able to make up for the prior year’s revenue shortfall. This solution works well for a company where it is harder to predict the specific timing of receipt of revenues in order to avoid a seller being penalized only because of delayed receipts.
- Operational Covenants, Control, Autonomy – As demonstrated by the financial metrics discussion above, sellers often seek commitments from the buyer to operate the acquired business in substantially the same manner as it was operated by the sellers pre-closing. These operational covenants may include specific obligations, such as requiring the buyer to provide the same level of resources to the acquired business that it received from the sellers pre-transaction. Buyers may reject these requests, particularly in light of the current pandemic and the anticipated need for the acquired business to adapt to changing circumstances or make necessary pivots. For example, it is unlikely that an agreement signed in 2018 that has a 3-year earn-out specifically addressed a pandemic. If that earn-out structure included an obligation that the buyer operate the business consistent with historical practices, the buyer that quickly pivots in order to maintain revenue and preserve the business (such as a clothing manufacturer switching to the manufacture of PPE instead) would technically be in breach of its obligations, even if its quick actions actually resulted in the business earning more revenue than if the buyer continued to operate in the ordinary course. In some cases, the sellers will also want information and audit rights to view information and financials used in tracking and calculating earn-out performance metrics. These points are often the source of contentious negotiations, but are important to consider and resolve in an effort to minimize future disputes.
- Transformative Changes – Sellers often seek to impose limits on what the buyer can do with the acquired business, such as requiring the buyer to agree that it will not divest any material assets or sell the business during the earn-out period. In such a case, rather than agree to restrict its future options, a buyer may agree to “accelerate” and pay any outstanding earn-out obligation for current or future earn-out periods to the sellers in the event of a transformational change, such as a sale.
- Setoff Rights – The buyer will want to be able to use the earn-out proceeds, if earned by seller, to satisfy any amounts (e.g., indemnification claims) owed by seller to buyer. Depending on the amount of consideration at issue, the length of the earn-out period, and buyer’s other indemnification rights (e.g., does buyer also have an indemnification escrow), sellers may resist this request.
These are just a few of the more common issues that arise when negotiating and administering earn-outs and the related covenants and obligations on both sides. Each earn-out differs, depending on, among other things, the overall deal structure, the parties involved, and the industry. It is crucial that parties carefully negotiate such provisions and keep in mind that what may be correct and appropriate today may no longer seem right one, two, or three years after the deal is signed.