Earn-outs are a common feature of many private company sale transactions. An earn-out is a mechanism that provides for a portion of the agreed purchase price for a business to be payable contingent on certain future conditions being met.

For example, an acquirer might agree to purchase a company for $60.0m but only pay $40.0m in cash up-front and deem a final payment of $10.0m to be contingent upon the company recording, say, at least $8.0m if EBITDA in the following financial year. That second payment is the earn-out.

Fundamentally, including an earn-out such as the one just described is a risk management mechanism that spreads the risk of an acquisition underperforming between a circumspect buyer and a bullish seller. It also provides an incentive for the seller to work hard after the deal closes.

King of all Stuff Ups

Let’s look at a real-world example of an earn-out in action. In August 2015, listed media management company Isentia acquired King Content, a content marketing business, for circa $47.0m. At the time of the acquisition, Isentia had very high hopes for the company.

In Isentia’s 2016 annual report, the company stated that on a full-year basis, King Content would have delivered revenue of $23.5m and NPAT of $3.3m and the business continued to push on aggressively with its global expansion plans.

However, the acquisition soured shortly thereafter. In the company’s 2017 annual report, Isentia announced that King Content had made a $4.4m EBITDA loss and that the acquisition was fully impaired (ie. worthless).

Perhaps the one saving grace for the company whose share price got hammered for the blunder was that the use of an earn-out cushioned the blow somewhat. As then CEO John Croll revealed to trade magazine Mumbrella:

Standard Earn-Out Provisions

There is no standard model for an earn-out. They are ultimately created through a process of negotiation with their possible dimensions being only limited by the creativity of the respective parties. Nevertheless, there are several standard issues that earn-outs address. Standard provisions include:

• The performance metric or metrics upon which the payment of the contingent consideration will be assessed. Most commonly, these metrics are financial such as a revenue or EBITDA target. However, they can also be non-financial such as being contingent on the launch of a new product and so on. In terms of financial metrics, sellers commonly prefer revenue as the key metric because it is less susceptible to interference as a result of the transaction.
• The time period over which the earn-out will remain in place. Earn-outs typically remain in place for one-to-three years, though they can be longer in certain circumstances. Typically, sellers prefer period to be shorter and acquirers prefer longer earn-outs to gauge the ultimate success of the acquisition.
• The structure of the earn-out in terms of how much of the total consideration will be paid up-front (ie. the non-contingent component), the milestones that need to be met along with their corresponding earn-out payments (or percentages thereof) as well as the maximum aggregate consideration payable under the transaction.

Important Issues with Earn-Outs

While sellers commonly dislike earn-outs because they tether themselves to the company and its future fortunes, they have become a standard feature of the M&A landscape and are an important tool in getting deals done.

To avoid an earn-out being a bad experience for both parties, there are many issues that need to be considered in negotiations:

• The business being acquired needs to be clearly defined in the context of the larger group. If the acquired business will be maintained as a separate entity and run as a stand-alone operation, that makes the definition relatively straightforward. However, if the acquired business is set to be fully absorbed into the acquirer’s operations, delineating the target’s business for earn-out purposes becomes more challenging.
• The definition of the performance metric or metrics underlying the earn-out need to be clearly defined. If EBITDA, say, is the chosen earn-out metric, how will EBITDA be defined? What will the relevant revenue and expense recognition policies be? How will any integration costs be treated? Will revenue be adjusted for any bad debts, capital expenditure and so on?
• There needs to be agreement on what happens if the acquired company only partially meets an earn-out milestone. For example, if an EBITDA target of $10.0m is set, what happens if the company only achieves $9.5m? Does the seller receive 95% of the earn-out payment or zero?
• The ongoing level of control that the seller will maintain over the business needs to be understood and agreed to. If the acquirer is free to make significant changes to how the business is run, then the seller, arguably, cannot be held accountable for the business’ performance.
• The ongoing level of support that the acquirer will provide the target into the future also need to be clarified. A common motivation for an owner in selling to a larger company is access to increased levels of marketing and distribution prowess. How, starting from when and out of who’s pocket the acquirer will support the target going forward, therefore, needs to be clarified.
• As an extension to the above point, a common motivation for an acquirer to complete an acquisition is the ability to extract synergies with the target company. An important consideration in negotiating an earn-out is the extent to which, if at all, these synergies will be shared with the seller when calculating an earn-out. For example, if the acquirer extracts new revenue by leveraging the seller’s existing client base, will the seller benefit from the increased sales?

Earn-outs are a common feature of many business sale transactions. It is important that any earn-out is carefully structured to maximise returns and minimise frustration and disappointment. If you would like to have a confidential discussion about how CFSG can assist you in successfully preparing for and completing the sale of your business, please contact us.