Earn-Out

An earn-out is a contractual clause in company sales or mergers that links part of the purchase price to the future performance of the company being sold. This structure makes it possible to defer part of the purchase price payment to a later date and make it dependent on the achievement of certain performance targets. Earn-outs are often used to bridge valuation differences between buyer and seller and to share risks.

Main features of an earn-out:

1. performance targets: Defined key performance indicators that the company must achieve within a specified period of time. 2. time frame: Typically 1-5 years after completion of the transaction. 3. additional payments: If targets are met, the seller receives additional payments. 4. staggered payments: Often staggered payments depending on the degree of target achievement.

Common performance indicators for earn-outs:

– Sales – EBITDA (earnings before interest, taxes, depreciation and amortization) – net profit – market share – customer numbers or retention – product development milestones – regulatory approvals

Advantages for buyers:

1. risk mitigation: shares the risk of future company performance with the seller. 2. bridging valuation gaps: Enables agreement in the event of differing values. 3. performance incentive: motivates seller/management to achieve business goals. 4. cash flow management: postpones part of the purchase price payment into the future.

Advantages for sellers:

1. higher total purchase price: potential for additional payments over and above the base purchase price. 2. value realization: opportunity to realize the full value of the company. 3. flexibility: allows sale in a potentially unfavorable market environment 4. participation in upside: benefits from positive developments after the sale.

Challenges and risks:

1. complexity: earn-out structures can be complex and difficult to administer. 2. conflicts of interest: possible divergence between short-term earn-out targets and long-term corporate strategy. 3. loss of control: seller may have limited influence on target achievement 4. calculation disputes: Disagreements over the calculation or interpretation of performance metrics. 5. risk of manipulation: risk of manipulation of key figures to influence the earn-out.

Legal and contractual aspects:

1. clear definitions: Precise definition of key performance indicators and calculation methods. 2. reporting obligations: Regular and transparent reporting of relevant key performance indicators. 3. audit rights: possibility for the seller to check the calculation. 4. dispute resolution mechanisms: definition of procedures for resolving differences of opinion. 5. adjustment clauses: provisions for unforeseen events or changes in the business environment.

Tax considerations:

– Timing of taxation: question of whether earn-out payments are treated as a deferred purchase price or as income. – Valuation: Challenges in the valuation of future, uncertain payments. – International aspects: Complexities in cross-border transactions.

Best practices for the design of earn-outs:

1. realistic goals: Setting achievable but challenging performance targets. 2. balance: balance between short-term goals and long-term corporate development. 3. flexibility: building in mechanisms to adapt to changing market conditions. 4. transparency: clear communication and regular updates on progress. 5. incentive structure: design that motivates both buyer and seller. 6. protective clauses: agreements to protect against manipulation or unintended consequences.

Alternatives and additions to earn-outs:

– Escrow agreements: Deposit of part of the purchase price as security. – Seller’s loan: Part of the purchase price as a loan from the seller to the buyer. – Option structures: Right of the buyer to acquire additional shares. – Milestone payments: Payments upon achievement of specific, non-financial targets.

Industry-specific applications:

– Technology: Often based on product development or user numbers. – Pharma/biotech: Often linked to regulatory approvals or clinical trial results. – E-commerce: Focus on customer numbers, conversion rates or revenue per customer. – Services: Often linked to customer retention or revenue per employee. In summary, earn-outs offer a flexible way of structuring transactions and distributing risks between buyer and seller. However, they require careful planning and execution to be effective and minimize potential conflicts. The successful implementation of an earn-out depends heavily on the clarity of the agreement, the appropriateness of the performance targets and the ongoing cooperation between the parties.