An Earn-Out is a structured payment mechanism often used in mergers and acquisitions (M&A) where part of the purchase price is contingent upon the future performance of the acquired company. This mechanism creates an incentive for sellers to achieve specific performance targets after the sale, ensuring alignment of interests between the buyer and the seller.
Definition and Mechanism
Basic Concept
An Earn-Out involves supplementary purchase payments that are not part of the original acquisition cost. These payments are based on the future earnings or other financial metrics of the acquired company surpassing a predetermined level.
Calculation and Example
The earn-out payment is usually a function of financial targets such as earnings before interest and taxes (EBIT), net income, or revenue. The structure might look like:
For instance, if Company A acquires Company B and an Earn-Out clause stipulates a payment of $1 million for every $10 million in revenue above a $50 million threshold, and Company B achieves $70 million in revenue, the Earn-Out Payment would be:
Types of Earn-Outs
Revenue-Based Earn-Outs
Payments are tied to the revenue generated by the acquired company. Suitable for businesses with unpredictable expenses but reliable revenue streams.
Profit-Based Earn-Outs
Payments depend on profits, typically EBIT or net income. More complex due to potential manipulation of expenses to alter reported profits.
Milestone-Based Earn-Outs
Payments are triggered by achieving specific non-financial milestones, such as regulatory approvals, launching a product, or expanding into a new market.
Special Considerations
Contractual Terms
Key terms in an Earn-Out agreement include the performance metrics, measurement periods, payment schedules, method of dispute resolution, and the degree of control the buyer has over the seller’s operations.
Potential Conflicts
Conflicts can arise under Earn-Out agreements due to differing interests and perceptions of performance between buyers and sellers. Dispute resolution clauses are vital to mitigate these risks.
Historical Context
Earn-Outs became prevalent in the 1980s as a tool to bridge valuation gaps in M&A transactions. They have evolved to address the complexities of modern business operations, providing flexibility in deal structures.
Applicability in Modern Business
Earn-Outs are commonly used in industries where future performance is uncertain and hard to predict, including technology, healthcare, and startups. They align the seller’s interest in ensuring the acquired business’s success post-acquisition, benefiting both parties.
Comparisons with Related Terms
Deferred Payment
Deferred payments delay payment but are not contingent on future performance.
Contingent Consideration
Broader than Earn-Outs, including payments based on events other than financial performance, such as achieving regulatory milestones.
FAQs
What are the benefits of Earn-Outs for buyers and sellers?
How are disputes in Earn-Out agreements typically resolved?
References
- Ross, S.A., Westerfield, R.W., & Jaffe, J. (2016). Corporate Finance.
- Damodaran, A. (2012). Investment Valuation.
- Bruner, R.F. (2004). Applied Mergers and Acquisitions.
Summary
Earn-Outs offer a flexible, performance-based solution in M&A transactions, ensuring both parties can reach an agreement reflecting both current and future business potential. Understanding Earn-Outs can significantly benefit both buyers and sellers in effectively structuring deals to minimize risk and maximize value.
