An earn out is a mechanism where part of the purchase price for a company or business is payable after settlement, contingent on the results of the target during the earn out period.  It’s one thing when the target performs as expected, but what happens when the unexpected occurs?

One unexpected event (at least for the seller) is when the buyer sells the acquired target during the earn out period.  Now what?

• Should the buyer have to pay out a lump sum to compensate the seller for the unexpired portion of the earn out period, even though the results of that period are unknown?
• Should the new buyer assume the earn out provisions and the restrictive provisions that the original seller inserted to protect those earn out provisions?
• What is the tax effect on the seller of this recalculation of the earn out?

It all depends on the circumstances, but I think one of the best solutions here is an earn out that accelerates a lump sum payment on the change of control of the target or the sale of all or substantially all of the target assets post settlement.  The unfortunate thing is that not many earn outs include such a clause.

Dealing with Conflict About the Earn Out

At the end of an earn out period, the seller, and to a lesser extent, the buyer, both want to pay the money owing and part on good terms.  The difficulty is that earn outs are often contentious and can end in litigation if disputes aren’t dealt with early on in the piece.  Forbes magazine reported that two thirds of deals in the US end up in disputes over earn outs and escrowed funds. The worst news is that most disputes arose in the final week of the escrow period, just when the seller thought they were home and hosed.

• The first method of avoiding conflict is to draft the earn out clause properly. I think it is better to pay a big law firm big money to get the right agreement than scrimp on legals and then have a battle at the end.  Even in my personal deals I pay for big firm advice, even though I am a lawyer and could do it myself.  Time and time again I find myself miles ahead because of something my lawyer has done or said. The cost of the advice has in the past been outweighed by the monetary benefit by factors of between 30-1 and 80-1.
• The second method is to put the problems I have outlined on the table during negotiations, look the other party in the eye and ask them straight how they would deal with them if they came up.  Get some agreement on it and put it into your documents.
• A third method is for the buyer to prepare the accounts of the target at the end of each period, then let the seller review and agree them.  If there is no agreement, have a clause that puts the matter to an independent firm of accountants and go 50/50 on the costs.
• Next, I would have a dispute resolution clause that the parties had to go through before litigation.  Agree up front which city it should be in what the procedure will be.  Most modern sale and purchase agreements have these clauses, but check it anyway.
• Then ensure that if there are indemnity payments or warranty claims, the payments for these are offset against the earn out.  Make these express rights instead of being silent on them.
• As most earn outs depend on accounting treatments, make sure your earn out clause specifies the accounting principles to be used right down to the line items.

Common Earn Out Issues

Here are some issues that come up time and time again in disputed earn outs.  These are the usual danger areas, though there may be more in individual deals:

• Amortisation of intangible assets
• Amortisation of goodwill charges
• Rates of depreciation and depreciation elections
• Capitalisation of expenses
• Allocation of overheads across different business units post-settlement (and by extension, across the target business)
• Extraordinary items and non-recurring items
• R&D expenses
• Marketing expenses
• Where revenue is the KPI: Gross sales or net sales and revenue recognition
• Where net income is the KPI: treatment of non-cash expenses such as higher depreciation associated with an adjustment of assets from book to market value post-settlement; allocation of overheads amongst different business units; how increased interest expenses associated with buying the target are to be allocated post-settlement
• If EBIT or EBITDA is the KPI: sellers want acquisition costs, interest on the loan to acquire the business and management fees allocated to running the target should be excluded; buyers want to include these items
• If there are extraordinary gains or losses in the target post-settlement: sellers want the gains included and losses excluded, buyers want the reverse
• If the target becomes part of the buyer’s consolidated tax group, sellers want tax payments excluded and buyers want them included.

Common Tax Issues

The Australian tax treatment of earn outs is discussed in an earlier post.

Another tax issue is whether the compensation for the new employment agreement for each shareholder staying on in the business is simple salary, or some or all of it is referable to the purchase price. Some of the things to look out for are:

• Is the period of employment exactly the same as the earn out period?
• Are the selling shareholders all employees of the target post-settlement?
• Is the reason for the contingent payment for KPIs of the business or simply payments associated with being an employee?
• Is the employee compensation consistent with employee performance and similar to other executives?
• Are there non-compete clauses?
• Any other matters that might indicate that payments are more in the nature of additional payments for the business rather than salary or benefits for an employee?

Summary

There are as many traps in earn outs as there are rewards.  Many earn outs end in disappointment for the seller.  This is not always because of bad faith or other fault of the buyer – sometimes the business just has to pivot or change in a way that was unanticipated by the earn out clause several years before.  Sellers can, however, minimise the possible disappointment by getting top notch corporate advice and big end of town legals to back it all up.

Disclaimer: I shouldn’t really have to write a disclaimer here about using this as legal or taxation advice as I am sure you are smart enough to work out that it is general commentary only and it may not suit your own personal circumstances.