Earn outs

What Are Earn Outs?

Earn outs, often referred to as earn-out clauses, represent a contractual mechanism within mergers and acquisitions (M&A) where a portion of the purchase price is contingent on the acquired business achieving specific future performance targets. These arrangements fall under the broader category of corporate finance, specifically designed to bridge valuation gaps between buyers and sellers. By deferring part of the consideration, earn outs align the seller's ultimate compensation with the business's success post-acquisition, often based on predetermined financial metrics or operational milestones.

History and Origin

Earn outs have been a feature of M&A transactions for many years, evolving as a flexible tool to facilitate deals, particularly when there is uncertainty surrounding the target company's future performance or a disagreement between buyer and seller regarding its worth. Initially, these clauses were more prevalent in high-growth sectors like technology and healthcare, where future projections were less predictable. However, during periods of economic uncertainty, their use has become more widespread across the mid-market M&A landscape as a means to bridge valuation discrepancies and successfully close transactions.²¹ The increasing complexity and risk in the M&A world have made deferring consideration an attractive proposition for buyers, while helping sellers secure the sale of their business.²⁰

Key Takeaways

• Earn outs are contractual arrangements in M&A deals where a portion of the purchase price is contingent on future business performance.
• They are primarily used to bridge valuation gaps between buyers and sellers who hold differing expectations about a target company's future growth.
• Common performance metrics for earn outs include revenue, EBITDA, or specific operational milestones.
• The duration of an earn out period typically ranges from one to three years, though it can vary.
• Despite their benefits, earn outs can be complex and are a common source of post-closing disputes.

Formula and Calculation

The formula for calculating an earn out is highly customized and defined within the specific contractual agreements of the M&A transaction, typically outlined in the share purchase agreement. There is no universal standard formula; instead, it depends on the agreed-upon performance metrics and payment structure.

A common earn out calculation might involve a multiple of a financial metric achieved over a specified period. For example:

$\text{Earnout Payment} = (\text{Achieved Metric} - \text{Threshold Metric}) \times \text{Multiplier}$

Where:

• (\text{Earnout Payment}) is the additional consideration paid to the seller.
• (\text{Achieved Metric}) is the actual performance of the acquired business (e.g., EBITDA, revenue, net profit) during the earn out period.
• (\text{Threshold Metric}) is the minimum performance level that must be met or exceeded to trigger an earn out payment.
• (\text{Multiplier}) is a pre-agreed factor applied to the excess performance.

Some earn outs might also include caps (maximum payment), floors (minimum payment, often zero), or tiered structures where the multiplier changes based on different performance levels. The specific terms are subject to extensive negotiation between the buyer and seller. An example of such a clause can be seen in public filings, where terms for prorated earnouts based on EBITDA thresholds are detailed.¹⁹

Interpreting Earn Outs

Interpreting earn outs involves understanding the interplay between the acquired business's post-acquisition performance and the structured payment terms. For sellers, a well-structured earn out can provide the opportunity to realize a higher overall sale price than might have been achievable upfront, especially if they are confident in the business's future growth prospects. For buyers, earn outs serve as a form of risk management, mitigating the risk of overpaying for a business whose future performance is uncertain. The payment is contingent on the company "earning" that portion of the purchase price.

The length of the earn out period, typically one to three years, is crucial as it reflects the parties' risk appetite and integration plans.¹⁸ If the seller remains involved in the business post-acquisition, the earn out also acts as a strong performance incentives to ensure their continued dedication to achieving the agreed targets.

Hypothetical Example

Consider "Tech Innovations Inc." (the seller) being acquired by "Global Holdings Corp." (the buyer). Both parties agree on an initial upfront payment of $10 million. However, they have different views on Tech Innovations' future growth potential. To bridge this gap, they agree on an earn out clause for an additional payment up to $5 million, contingent on Tech Innovations' financial performance over the next two years.

The earn out terms are structured as follows:

• Earn out period: Two years post-closing.
• Metric: Annual revenue growth.
• Threshold: If annual revenue grows by more than 15% in either year.
• Payment: 50% of the revenue growth above 15% will be paid as an earn out, capped at $2.5 million per year.

Year 1:
Tech Innovations achieves 20% revenue growth.

• Growth above threshold: (20% - 15% = 5%)
• Assume Year 1 revenue was $10 million. 5% of $10 million = $500,000.
• Earn out payment for Year 1: (50%) of $500,000 = $250,000.

Year 2:
Tech Innovations achieves 10% revenue growth.

• Growth above threshold: (10% - 15% = -5%) (no growth above threshold)
• Earn out payment for Year 2: $0.

In this hypothetical example, Tech Innovations Inc. earns an additional $250,000 through the earn out clause, based on its performance in Year 1. This illustrates how the earn out mechanism provides flexibility in the acquisition price, aligning it with future outcomes.

Practical Applications

Earn outs are widely applied in M&A transactions across various industries, particularly where future performance is subject to higher uncertainty or where significant growth is anticipated. They are prevalent in sectors such as pharmaceuticals, technology, and startups, which often have less predictable revenue streams or rely heavily on future product development.¹⁷,¹⁶

Beyond bridging valuation gaps, earn outs also serve several other practical purposes:

• Aligning Post-Closing Incentives: Earn outs often require the seller's key management or founders to remain involved in the acquired business for a period, ensuring their continued motivation and dedication to achieving targets.¹⁵
• Risk Sharing: They allow buyers to mitigate the immediate capital outlay and share the operational risk of the acquired company's future performance with the sellers.¹⁴
• Financing Solutions: In challenging M&A financing environments, earn outs can help facilitate deals by deferring a portion of the purchase price, reducing the upfront cash requirement for the buyer.¹³
• Addressing Information Asymmetries: Earn outs can help overcome situations where the seller possesses more detailed information about the business's prospects than the buyer, making the buyer more willing to pay an additional amount once the corresponding value is observable.¹²

The accounting treatment of earn outs, particularly distinguishing between contingent consideration and variable remuneration, is guided by standards like IFRS 3 in business combinations.¹¹,¹⁰

Limitations and Criticisms

Despite their utility, earn outs come with notable limitations and are a frequent source of disputes in M&A transactions.⁹

• Potential for Disputes: The subjective nature of defining and measuring performance metrics can lead to significant disagreements. Buyers might make operational decisions that, while beneficial for the overall combined entity, inadvertently hinder the acquired business from meeting its earn out targets. Sellers, conversely, may manipulate expenses or overstate revenue to trigger payments.,⁸ Lack of clear definitions and dispute resolution mechanisms in the initial contractual agreements is a primary cause of litigation.⁷
• Loss of Control for Sellers: Once the acquisition closes, sellers typically lose direct control over the day-to-day operations of the business. This lack of control can make it challenging to influence the factors necessary to achieve earn out targets, even if they remain actively involved.⁶ Buyers, on the other hand, usually retain sole discretion over the operation of the business.⁵
• Measurement Challenges: Choosing appropriate financial metrics (like revenue, EBITDA, or net profit) and ensuring consistent accounting principles for measurement can be complex. Changes in accounting policies post-acquisition or unexpected external events (e.g., economic downturns) can significantly impact performance, making targets difficult to meet.⁴
• Short-Term Focus: Earn outs tied to short-term metrics might incentivize sellers to prioritize immediate gains over long-term strategic investments or integration efforts that could benefit the business in the long run.³

Effective due diligence and careful drafting of earn out provisions are critical to mitigating these risks and ensuring a smoother post-acquisition period.

Earn Outs vs. Deferred Consideration

While often used interchangeably, "earn outs" are a specific type of "deferred consideration". Deferred consideration refers to any portion of the purchase price in an acquisition that is paid to the seller at a later date, rather than entirely at closing. This payment can be fixed, known, and simply paid over time, or it can be contingent on future events.

Earn outs specifically fall into the contingent category of deferred consideration. They are payments that must be earned based on the future performance of the acquired business, tied to specific metrics or milestones. Other forms of deferred consideration might include fixed payments on certain anniversaries, or payments contingent on non-performance-based events, such as the achievement of a regulatory approval, rather than financial results. The key distinction is the performance-based contingency inherent in earn outs.

FAQs

What is the primary purpose of an earn out?

The main purpose of an earn out is to bridge a valuation gap between a buyer and a seller in an M&A transaction. It allows the seller to receive additional compensation if the acquired business performs well post-acquisition, while reducing the buyer's upfront payment and mitigating their risk.

What types of performance metrics are typically used in earn outs?

Common performance metrics include financial measures such as revenue, gross profit, EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), or net income. Non-financial metrics like product development milestones, customer retention, or regulatory approvals can also be used, depending on the nature of the business.

Are earn outs common in M&A deals?

Earn outs are a common feature in M&A transactions, especially in periods of economic uncertainty or in industries with high growth potential. They are a flexible tool that helps facilitate deals by aligning the interests of both parties. A substantial percentage of deals, particularly in high-growth segments, include earn out clauses.²,¹

How are earn outs typically taxed for the seller?

The tax treatment of earn outs can be complex and depends on the specific structure of the earn out and the relevant tax jurisdictions. Generally, if the earn out is considered part of the purchase price for the sale of a business, it may be taxed as a capital gains. However, if it's structured as compensation for continued employment or services, it may be subject to ordinary income tax. Sellers should consult with tax professionals to understand the implications for their specific situation.

What are the main challenges associated with earn outs?

The primary challenges with earn outs include potential for disputes over measurement and operational control, the seller's loss of influence over the business, and the difficulty in accounting for unforeseen circumstances that impact performance. Clear and detailed contractual agreements are essential to minimize these risks.