partner feature


Earn-outs: some practical considerations


E


arn-outs can be a fair way to bridge any valuation gab between sellers and a buyer, and are frequently used where the sellers’ ongoing


involvement is critical to the development of the business. Although the nature of the contractual


protections relating to earn-out payments will be driven by the characteristics of the underlying business and the type of earn-out, certain key points should be considered. An earn-out involves structuring the


consideration for a business as a payment at completion, followed by one or more subsequent payments at later dates based on the future performance of the business. Although there is often significant alignment


of the parties’ interests in an earn-out, there is also a natural tension. Buyers will want to ensure that any earn-


out payment is determined by reference to some measure of ordinary course performance, and not inflated by deferring expenditures and investment. Sellers will want to maximise the earn-out


payment and will also want to ensure that performance is not artificially manipulated by a buyer charging excessive management fees, for example, or unnecessarily increasingly investment and capital expenditure during the earn-out period. The recent case of Porton Capital


Technology Funds and others v 3M UK Holdings Limited and another highlighted the need to consider carefully the rights and obligations of the parties during an earn-out period.


Although the nature of the contractual


protections relating to earn-out payments will be driven by the characteristics of the underlying business and the type of earn-out, key points to consider in relation to an earn- out include the following: Sellers’ ongoing involvement If the sellers are to continue as senior employees of the business, they will expect to be allowed to run the business in the ordinary course without undue interference. Equally, the buyer will be keen to ensure that it is not


10 THEbusiness QUARTER


prevented from terminating the employment of the sellers if they are guilty of misconduct, and that it has sufficient controls over the business to prevent the sellers from acting in a short-term or opportunistic manner t the expense of the long-term prospects of the business. Care should be taken if there is to be any


link between earn-out payments and a seller’s continued employment with the business in order to avoid the earn-out payment being treated as employment income, and to avoid any earn-out payments being treated as expenditure (which would reduce the buyer’s profits), rather than as a capital item. Buyer’s conduct of the business If the sellers will not be employees of the business following completion, the contractual protections they negotiate over the buyer’s conduct of the business during the earn-out period will be of real importance to them. They will want a commitment from the


buyer to run the business in the ordinary course, and not to act in a way intended to reduce the amount of the earn-out payment. The buyer will want to limit the scope of


its contractual or other obligations to the sellers and will look to reserve the right to take whatever steps it considers necessary to protect its investment. Level of support To the extent that the business is not standalone, the sellers will want to ensure that it is adequately supported during the earn-out period on acceptance terms; whether through the provision of financial support and sufficient working capital as envisaged by the agreed business plan, access to internal resources such as marketing and sales forces, or otherwise. The sellers should also consider the extent


to which the buyer should be restricted from extracting surplus cash from the business or whether this should be re-invested to drive future performance. Level of investment The sellers will not want the business to incur significant expenditure on matters such as research and development and capital expenditure, if the full benefit of the


expenditure will only be felt towards the end of, or even after, the earn-out period. Conversely, a buyer may not be prepared


to restrict the business’ R&D budget or capex during the earn-out period because it may undermine the long-term growth of the business. One solution is to agree that any capex


during the earn-out period above an agreed limit will be added back in to the calculation of profits for earn-out purposes. Group resources If the acquired business becomes part of a larger group the buyer may, for example, want to use the sales force from the acquired business to sell its other products and services, or might want to use the acquired R&D team to develop products for other group businesses. Sellers will be concerned if these functions


are used by the group to such an extent that they can no longer support the acquired business properly, or if their use results in higher expenditure within the business, as this could decease any earn-out payment. Depending on the circumstances, the


buyer may be willing to agree that if it uses the resources of the acquired business in this way, the acquired business will be paid (or credited for) the services provided on an arms’ length basis. Impact of acquisition It is difficult to determine the benefits that the business may derive from the acquisition. If significant post-acquisition synergies


are anticipated (for example, reductions in personnel, shared services and/or cheaper borrowing costs for the business, and greater purchasing power of a larger group), the parties will need to work out if they can be quantified in practice. A buyer may be unwilling to pay an


increased earn-out if the post-acquisition performance of the business is solely underpinned by post-completion synergies. Similarly, sellers will be reluctant to allow


their ability to achieve their earn-out to be prejudiced by any upfront costs required to achieve the synergies (such as relocation or


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