Earn-outs in fire sales - chance or risk?

published by InsolvenzBlog

In our last article we from Corporate Finance Mittelstandsberatung GmbH (CF-MB) pointed out to what extent an fire sale can be the proverbial last straw for entrepreneurs who are affected by an impending insolvency. In this article, the topic is taken up again and deepened with regard to a part of the purchase agreement which has become particularly popular in the course of the Corona crisis - the earn-out regulation. Earn-outs are often used especially for medium-sized deals with a volume of less than 100 million Euros. Entrepreneurs interested in selling should know the opportunities and risks of earn-outs in the run-up to negotiations to ensure that their life's work is ultimately sold at fair conditions.

What is an earn-out arrangement?

When agreeing earn-outs, a company purchase agreement is structured in such a way that part of the purchase price depends on the future development of the target company. In concrete terms, an earn-out arrangement divides the purchase price into two components: a fixed payment that is due immediately and a performance-related payment that the seller receives later, provided that the company reaches certain previously defined milestones. Financial parameters (such as the development of sales or operating profit) are often used as performance indicators because they are usually the easiest to calculate and, if defined precisely, are difficult to manipulate. In practice, earn-outs help to bridge different price expectations between buyers and sellers and thus address a classic conflict in M&A deals: The buyer wants to pay the lowest possible purchase price, while the seller wants to achieve the highest possible proceeds.

Risks for the seller

The exact end of the corona pandemic can only be estimated to a limited extent at present. The point in time when the markets will recover and overall economic demand will increase again is therefore also uncertain. As the payment of the performance-related component depends mainly on the positive development of the business, the seller runs the risk of selling his company below value. Experience shows that earn-outs often account for between 10 and 20 percent of the purchase price. The seller should therefore ensure that he can realistically achieve the agreed targets.

A further risk is that after the transaction the buyer usually wishes to have the flexibility to run the business at his own discretion, which may also involve a change in strategic direction. Sellers should therefore make sure that they still have sufficient influence on the business development to be able to achieve their earn-out. The premises under which the company will be continued should therefore remain comparable with those prior to the sale. Otherwise the buyers could, for example, impose high overhead costs on the new acquisition - a trick to make it significantly more difficult to reach the agreed milestones. Accordingly, sellers should only accept earn-outs if their management can stay on board for at least another year and influence further developments.

Opportunities for the seller

A major advantage of the earn-out rule is that it gives sellers time. Many medium-sized companies have lost sales in recent months, which has led to a tight liquidity situation. Planned investments have been put on hold and short-time work had to be announced for employees. In view of this initial situation and an uncertain market environment, many companies can currently only be sold with massive concessions on the selling price. Through the earn-out clause, sellers have the opportunity to bait potential buyers with a comparatively low fixed price, as the performance-related purchase price component only has to be paid if the company develops positively. However, if the Corona crisis should end in the foreseeable future, the overall economic recovery will lead to the aforementioned positive development of the key financial figures. This in turn will result in the payment of the agreed earn-outs. Thus, the seller can ultimately receive a fair price for his life's work, despite the crisis.

What do buyers have to consider?

When formulating the earn-out provision, buyers must pay particular attention to the agreements relating to the duration and the participation of the seller after the closing. Ideally, the seller remains involved in the transition phase, the buyer can benefit from the technical and operational know-how of the seller and his strong customer relations, while the earn-out clause creates an incentive for the seller to remain motivated and committed. A potential pitfall, however, relates to the case that the earn-out period is chosen too short while the management of the company is still in the hands of the seller. In the worst case, the seller could use his influence on the management to increase the result in the short term with risky decisions. In order to avoid false incentives of this kind and to prevent the seller's behaviour from counteracting the long-term plans of the buyer, a one- to three-year earn-out period should be agreed.

Final review

It could be shown that the earn-out clause in sales contracts contains numerous opportunities and risks (for buyers and sellers alike). In order to counteract problems, a clear explanation of the individual obligations of the parties and a precise definition of what may be done during the earn-out period is indispensable. In any case, a fair solution for both parties should be worked towards so that the transaction is not jeopardised and a future successful development of the company can be ensured.

The above scenarios illustrate perhaps the greatest strength of earn-out arrangements: They can be designed flexibly. If both sides have difficulty agreeing on the timing and amount of payments, for example, phased arrangements can be a compromise. To this end, buyers and sellers define different thresholds for payments of different amounts. Depending on which threshold is ultimately reached, the buyer pays a small, medium or large earn-out amount. In order to achieve the best possible result, it is advisable in any case to allow sufficient time during the M&A negotiations to work out the earn-outs.

At a glance

• Earn-outs refer to a contractual provision in a company purchase agreement according to which part of the purchase price depends on the future development of the target company
• By agreeing on earn-outs, sellers increase their chances of finding a buyer for their company even in times of crisis and receiving a fair purchase price for their life's work
• Potential pitfalls of the earn-out agreement relate in particular to the duration of the earn-out period and the seller's right to a say in the transitional period following the M&A transaction
• Earn-outs can be designed flexibly. In order to counteract subsequent problems, the parties should allow themselves time during the negotiation to discuss all eventualities of the later cooperation and to fix them contractually