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16 corporate finance Earn-outs to be handled with care


Earn-outs are fairly common on corporate transactions, especially where there is a valuation gap between seller and buyer. However, if they are not dealt with carefully in the transaction documentation then earn-outs can convert a disagreement over price at the time of the deal into future litigation over unexpected outcomes, writes Jonathon Roy of Paris Smith


In addition to the risk of unforeseen events, there is a natural tension between the interests of the parties during the earn-out period; buyers will want to ensure that they have freedom to operate the target and protect their investment, and sellers will want to maximise the earn-out and avoid any artificial manipulation by the buyer.


A detailed discussion of how the target’s business is likely to be operated post completion, and the potential impact on the earn-out of a range of business decisions, can help to mitigate such tensions, or at least enable all parties to assess some of the risks involved.


Even if the parties are able to negotiate detailed earn-out protections, they need to consider how such protections are to be quantified – this is often not considered in sufficient detail until the time for preparing the earn-out accounts, when it is too late to decide that the requisite multiple accounting adjustments are impractical.


Parties sometimes rely just on a general protection, for example to ensure that the business of the target is carried on in the ordinary course and substantially in the same manner as pre-completion, or prohibit the buyer from procuring that the target does anything which is intended to reduce the earn-out payment and is not commercially justified. The problem with such provisions is that they are often either of little practical value to the sellers and/or so general and wide ranging that they invite subjectivity and ambiguity. Some more specific areas to consider when negotiating earn-out provisions are listed below.


Seller’s ongoing involvement


A key issue for the sellers will be the extent to which their ongoing roles during the earn-out period are secured, and therefore the likelihood of them being in place to monitor and maximise the earn- out. However, the buyer would prefer to have some scope for removing the sellers – often the issue is whether such removal rights should be only in circumstances of gross misconduct (at one end of the scale) or for general underperformance (at the other end).


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The consequences of any fundamental changes to the nature and scope of the target’s business will need to be discussed, including the impact on the earn-out of other acquisitions made by the target. There are a number of ways in which such onward purchases can be addressed; for example, by giving the sellers an absolute veto (so that they can ensure that the target continues to operate on a stand-alone basis, and the earn-out is not distorted by acquisition costs or integration problems) or a conditional veto eg not to be withheld unreasonably (although following recent case law, the buyer should be aware that it can be difficult to prove unreasonableness in this context); or deeming permission subject to the earn-out being crystallised pursuant to an agreed formula and/or being accelerated and/or being subject to an uplift contingent on any increase in the onward sale value relative to the current transaction; or in deeming permission subject to the ringfencing of the target’s operation to enable the earn-out to be calculated.


Arrangements with the buyer’s group


Consideration should be given to such matters as intra-group trading, the imposition of intra-group charges, the provision of intra-group facilities, the impact of group arrangements with third party suppliers (eg audit fees and insurance costs), differences in group- imposed remuneration arrangements (especially the impact of bonus arrangements and pension contributions), the cost of new management and the risk of the sellers or their senior managers being seconded within the group, the benefit of synergy savings, and whether or not for the purposes of the earn-out calculation commission should be payable for work referred to the buyer’s group by the target and/or whether a deduction should be made for work referred to the target by the buyer’s group.


The sellers will want the target to be treated fairly in terms of intra-group arrangements, including the availability of financial support, and prevent cash generated by the target from being swept upstream within the buyer’s group to the detriment of its working capital requirements. They will also want a commitment from the buyer’s group not to compete with the target during the earn-out.


The sellers will want to at least have visibility on the earn-out period budget for costs (eg R&D, Capex, Restructuring) that may not realise a commensurate uplift to the earn-out payment.


Impact of acquisition


Any direct or indirect consequences of the transaction itself, such as rebranding, relocation and redundancy costs, should be taken into account. Also, the sellers should ensure that they are not doubly penalised if a claim made against them under the warranties or indemnities contained in the sale agreement relates to subject matter that also causes the earn- out to be reduced.


Conclusion


To maximise the likelihood of an earn-out fulfilling the expectations of all parties, detailed input is required from legal, tax and accounting advisers; and ultimately from the parties themselves.


Details:


Jonathon Roy 023-8048-2301 jonathon.roy@parissmith.co.uk


THE BUSINESS MAGAZINE – SOLENT & SOUTH CENTRAL – JUNE 2012


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