Earn-Out
What Is an Earn-Out Agreement in a Business Sale?
In a business sale, an earn-out agreement means that the buyer divides the purchase price into a fixed portion and a variable portion. The variable portion is then tied to the achievement of specific targets and is paid out only after the transfer of the company shares. Earn-out clauses are a key consideration in many business sales or succession plans. Generally, they are considered an effective way to reduce risks for the buyer and to reconcile differing expectations regarding the sale price.
The fixed portion of the purchase price is usually credited to the seller’s account immediately after the contract is signed. An earn-out payment, on the other hand, is not due until certain conditions are met. The buyer thus gains time and can cover the variable portion of the purchase price using the ongoing revenues of their new company. After a business sale is completed, earn-out clauses are often the subject of legal disputes, as they are advantageous to the buyer.
An Uncertain Future—Earn-Out Agreements
Earn-out agreements must be accounted for differently depending on how they are classified. Compensation or contingent purchase price payment? Especially in times of economic uncertainty, buyers and sellers may have differing assessments of future performance and divergent views on the company’s purchase price. To still be able to close the transaction, additional payments—known as earn-outs—that depend on the company’s future performance are often agreed upon in addition to a preliminary purchase price. Financial metrics such as EBITDA and EBIT are typically used as benchmarks for the company’s earnings performance.
The accounting treatment of earn-out agreements depends on various factors and can have a significant impact on the acquiring company’s overall financial position, cash flow, and profitability. The rules for accounting for earn-out clauses under the widely adopted International Financial Reporting Standards (IFRS) were revised for business acquisitions effective as of the 2010 fiscal year. As a first step, it must therefore be determined whether the additional payments are related to the acquisition of the company (contingent purchase price payment) or whether, from an economic perspective, they constitute compensation for employees of the acquired company. The latter must be examined in particular if the seller—such as a former managing partner—continues to be employed after the transaction.
If an earn-out clause is considered compensation for employees, it is generally recognized as personnel expense over the agreed-upon (minimum) service period. A reduction in fair value is recognized as income. If the earn-out clause is classified not as compensation but as a contingent purchase price payment, a distinction must be made as to whether the contingent consideration should be classified as a liability or as equity. Subsequent purchase price payments, which are very common in practice, are classified as liabilities. They are initially recognized at the fair value of future payments and generally increase the goodwill arising from the business combination.
Changes in fair value occurring after the acquisition date—such as those resulting from earnings performance that deviates from the plan—are generally recognized in income. If the acquired company performs worse than originally estimated, this often leads to a reduction in the fair value of the contingent consideration, which must be recognized as revenue in the income statement. Given the sometimes significant impact of subsequent changes in the fair value of the contingent consideration on the company’s financial and financial position, and profitability, it is advisable to conduct analyses of the fair value and its potential future fluctuations as early as the acquisition process.
Authors:
Michael Oppermann, Head of Financial Accounting Advisory at EY
Andreas Grote, Partner in the Financial Accounting Advisory practice at EY.
Use of Earn-Out Clauses
An earn-out is often used when a company’s future economic performance is difficult to predict, such as when acquiring a startup or a company whose economic success depends on the individuals involved. The buyer ties the purchase price to specific targets that must be met. The definition of these targets is left to the contracting parties. This could involve acquiring a specific number of new customers or meeting a clearly defined revenue target. It is up to the negotiating parties to assess whether such a target is realistic.
Buyers often attempt to use profit as the basis for calculating earn-out clauses. Based on practical experience, this is not advisable, as profit can be manipulated much more easily through skillful cost management than a comparatively rigid revenue or new-customer target. In general, earn-out clauses in business sales are a tool for the buyer, because if the agreed-upon targets are not met, the variable portion of the purchase price may be forfeited entirely. It is therefore essential to clearly define one’s negotiating position vis-à-vis the buyer in advance.
In this sense, negotiating an earn-out clause in a business sale always involves the seller assuming a future economic risk. This also goes hand in hand with diminishing rights to have a say in the matter. In short: In this case, a seller is negotiating away their decreasing room for maneuver. Experience shows that it helps to bring in a transaction-experienced advisor by this point at the latest. Drawing on the advisor’s project experience allows for the development of realistic earn-out models and a clear negotiation strategy. In summary, earn-out clauses in a business sale can dramatically accelerate negotiations. From the seller’s perspective, however, they should be used with great caution.
When should an earn-out payment be considered in M&A deals?
If, during the acquisition of the company, the classic conflict arises—namely, a significant and insurmountable gap between the buyer’s and seller’s price expectations—both sides should consider an earn-out payment. As a rule, they have already exhausted other options, performed multiple calculations, and engaged in lengthy negotiations—albeit to no avail. Now, a management consultant will bring the earn-out payment into play.
What can be problematic about earn-outs?
In the context of M&A deals, the principle sounds appealing. Nevertheless, the agreement is a potential powder keg. For one thing, it imposes a residual business risk on the seller, since the seller ultimately receives the payment only if the company performs as expected. If it does not develop as expected, this need not be the successor’s fault, as markets can change. As a result, the seller would forfeit a share of the company’s value of up to 20 percent, since earn-out payments are typically set at that level (rarely below 10 percent). The buyer, in turn, may be burdened by the payment during a turnaround phase, when they actually need the liquidity for their own business. However, since they cannot know in advance whether the turnaround will succeed, they prefer to rely on the earn-out payment rather than an upfront payment of the entire purchase price.
Practical Implementation in the Context of Business Succession
This approach is very commonly used in deals involving medium-sized companies with a transaction value not exceeding 100 million euros. It is particularly suitable when the company is in a growth phase. If this growth is not hindered by the business succession, the seller may receive more money. There are also sellers whose companies are currently undergoing a restructuring phase and who, for that very reason, want to split the purchase price in this way.
This is intended to motivate the buyer, who—due to the costly restructuring—initially sees weak financials and therefore does not believe a high valuation is warranted. The buyer is, of course, informed about the ongoing turnaround. If it is successful, the buyer will view the payment in one to two years as justified. If the company does not recover as hoped, the buyer may not have to make the payment. It may also end up being very small.
Tip: Conduct M&A negotiations thoroughly!
Essentially, the seller wants to retain influence over the M&A target in order to receive the payment. The buyer, however, wants the former owner’s influence to be limited at most. The terms for this must be negotiated precisely. Otherwise, the earn-out payment will not achieve the desired fairness but may, under certain circumstances, create perverse incentives. Therefore, sufficiently intensive M&A negotiations are always recommended for such an arrangement.
Author: Ingo Claus, Partner at K.E.R.N.