The earn-out in company purchase and sale transactions

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Félix Navas Mir

With the earn-out clause, the buyer and seller set the criteria that will be used to determine the variable price of a transaction if certain conditions (usually financial or business development) are met in the short to medium term in the target company. The parties usually use the earn-out formula if there is uncertainty about the future performance of the company. Thus, if the expectation of future profit is high, the seller will want to receive a higher earn-out, and the buyer will be willing to pay a higher variable price.

One of the usual criteria for setting the earn-out is to adjust the deferred payment to the fulfilment of a business plan, at different time periods, taking EBITDA (earnings before interest, taxes, depreciation and amortisation) as a reference. Thus, depending on the degree of EBITDA compliance established in the business plan, the parties will quantify the variable price to be paid by the buyer. To establish how to calculate the earn-out, the performance variable to be measured must be taken into account; the values per tranche that the variable must reach; the consideration (which is usually monetary); and the payment period once the earn-out has been accrued (which may be fixed or deferred).

It is important that the clause in question is clear and precise, and the parties must (as indicated above) clearly agree on the earn-out calculation formula, and establish mechanisms so that the seller can monitor the evolution of the business and the achievement of its objectives. It is also useful to foresee, in the event of any discrepancy over the final amount of the earn-out, the possibility of an independent third party (normally an auditor) issuing a binding opinion on the variable price to be paid, following the criteria established in the clause in question.

Advantages of the earn-out for the buyer

Firstly, the buyer limits its economic risk, as it will only pay the deferred price if the parameters set out in the clause in question are met during the years following the execution of the transaction. Secondly, it is an effective way of valuing the total price of the company to be acquired and its growth potential. If the earn-out formula is well thought out, the buyer will pay a fair price for the company it is acquiring. Thirdly, the buyer is able to defer payment of part of the price (the variable price) over time, with the resulting benefits for its cash flow.

Advantages of the earn-out for the seller

The seller will sometimes continue to manage the company, or even hold part of the target’s share capital, for some time after the transaction has been completed. This is an attractive aspect for the seller in terms of setting the earn-out, as the seller will use all its means to increase the target’s profit, given that it will receive a higher earn-out.

Notwithstanding the above-mentioned advantages, the earn-out increases the complexity of the transaction, as the parties must agree on the criteria to be used to determine the price variable, which is an essential element in any transaction. If the parties do not objectively and measurably define the criteria for calculating the deferred price (as indicated above), disputes will arise, possibly ending up in court.

In conclusion, we can affirm that the ideal structure is for the transaction to be provided only with a fixed price, as the conflict arising from the setting of the earn-out can be high, both during negotiation and at the time of the accrual of the variable price. However, given the nature of the transaction in question, the parties often resort to this mechanism (the earn-out), and it is essential to follow the criteria indicated in this article to avoid conflicts between the parties.

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