Merger and acquisition deals are tricky transactions that require guidance from business law professionals. One crucial consideration you must have as either the buyer or the seller of the target company is how to structure the earn-out. Learn more about earn-outs in mergers and acquisitions and how to make them work for you.
What are earn-outs?
An earn-out is a negotiated payment arrangement between the buyer and seller. It takes place over time. In an earn-out, the seller has to agree to receive at least part of the purchase price as one or more contingent payments after closing on the sale.
The timing of the deferred payments is usually determined by operational benchmarks that the target company has to meet. Keep in mind that an earn-out isn’t the same thing as a purchase price adjustment.
In an earn-out arrangement, the seller usually continues to work in the business and thus influences the company’s performance. If the business performs as expected, the seller receives one or more payments.
Structuring Earn-Outs: What to Know
The provisions of the earn-out have to be structured to meet the needs and expectations of both parties.
Financial Metrics
Typically, earn-outs are structured so that the earnings before interest, taxes, depreciation, and amortization (EBITDA); gross profit; or gross revenue milestones are met. Buyers will usually prefer metrics that focus on the EBITDA, because it tends to be the most reliable indicator of the company’s performance.
Gross profits are usually compromise milestones. That said, gross revenue milestones work well for the seller because they are not as easily manipulated by the buyer.
You can also consider structuring the earn-out without basing it on financial goals. In pharmaceutical companies, for example, the milestones can be getting FDA approval or completing a clinical trial.
Time Period
This dictates by what time the financial or non-financial milestones need to be met. Usually, earn-outs take place between one and three years.
Minimum and Maximum Payments
Some types of earn-outs require a minimum payment in the future, while others establish a maximum payment. If you settle on a minimum payment in the future, the seller will likely want that put into an escrow account.
Graduated or All-or-Nothing Payments
You also have to decide whether there’s an absolute milestone that the seller has to meet before they earn any payment or whether a graduated milestone works best.
Accounting Standards
To determine whether the financial metrics have been met, you will need to settle on an accounting standard. You can choose to follow the seller’s accounting standard, the buyer’s accounting standard, or generally accepted accounting principles.
Protective Provisions
Another important aspect of structuring an earn-out is to negotiate certain provisions to protect the possibility that the earn-out will be paid. The seller will generally ask the buyer to operate the acquired business in good faith.
They may also ask the buyer not to take affirmative actions or not to omit taking action in order to reduce or prevent the earn-out payments. In addition, sellers might ask buyers to provide ongoing financial support to the business they acquired.
Preparing for Merger and Acquisition Deals With Business Law Professionals
Are you getting ready for a merger or acquisition deal that will have an earn-out structure? If so, turning to business law professionals for guidance can be helpful for both buyer and seller.
At Sul Lee Law Firm in Dallas, TX, we offer the assistance you need to make business transactions as simple as possible. Our team of experienced lawyers is ready to guide you. Contact Sul Lee Law Firm in Dallas, TX, to speak with a business lawyer.