The earn-out clause in a business sale contract
Januray 2008
As part of a business sale, negotiations between the buyer and seller often become more difficult when the time comes for the parties to agree on the sale price. The buyer will want to take a cautious and conservative approach to the company’s capacity to generate profits while the seller wants to be more positive and can sometimes overestimate future revenues of the company. Now we know, it is precisely a company’s capacity to generate profits which in principle determines its value.
In light of such an impasse, the parties often choose to include a price adjustment clause of the sales price according to future profits. This clause is known as the earn-out clause.
Definition
The earn-out clause is a contractual provision stating that the seller of a business is to obtain additional future compensation based on the business achieving certain future financial goals. In other words, the buyer agrees to pay the vendor an additional amount if the business financial performance expectations set by the parties are realized in an established time frame.
Earn-out is a contractual provision stating that the seller of a business is to obtain additional future compensation based on the business achieving certain future financial goals.
Earn out clauses are part of business purchase agreements which sets a portion of the price contingent upon the business achieving some future financial goal. These clauses are included when the buyer and seller disagree significantly over what the business should be worth. This is especially so if its financial performance is expected to improve substantially at some future time, after the purchase. In such cases, the purchase agreement may set an additional amount that the seller will receive in the future if this financial performance expectation is realized.
Utility
If there is a dispute, this clause allows the parties to agree on a sale price. On one hand, the seller can hope to receive the desired price if the expected results are met. On the other hand, the buyer feels reassured by the fact he has not paid too much should the business not be as profitable as expected.
Conditions
There are no specific rules under which such a clause must be drafted and it can therefore take many different forms depending on the context. The terms of this clause will be the result of negotiations between the parties. To better illustrate how it functions, let us use the following example (see endnote)
Buyer “B” agrees to purchase from Vendor “V” all the shares of the company “C” for the sum of $1 000 000 payable as follows:
- 750,000 $ payable at the closing of the transaction;
- The balance of 250,000 $ will be payable by B in two years provided that the financial statements of the company « C » show earnings of $200 000 before income taxes, interests, depreciation and amortization. If this goal is not achieved, the balance of $250,000 is not payable.
Pitfalls
As we see, the principle in itself is very simple. However the drafting of such a clause has pitfalls to avoid. There are many but for the purposes of this article we will only name the following:
- Prevent the buyer from manipulating the figures: Ensure that the failure to achieve the goal is not the outcome of the buyer. For instance the buyer could deliberately prevent fixed goals from being reached by temporarily adding unjustified expenditures to reduce the company's profits).
- Beware of vague concepts: Ensure that the objectives are very clear in order to avoid erroneous interpretations. It may be necessary to agree beforehand on certain accounting standards as well as on the inclusion or exclusion of certain extraordinary events.
- Determination of goals by a qualified independent third party: determining achievement of the goals must be done by an independent third party (such as the company’s external auditors) and it is important that the company's financial statements be audited.
- Taxation, or how to avoid surprises: It may also be important to discuss the fiscal impact of this clause. What will be the tax treatment of the additional payment? Parties should consider the issue from the start with their advisors since the drafting of the clause can have a significant impact on its tax treatment.
- Relationship between the Parties: It may be advantageous for the Seller to remain active in the company to ensure that efforts are made towards goal achievements. Sometimes the buyer may sometimes may want to use this clause to keep the seller interested in the company's success regardless of the sale of his interests. How both can work together remains to be seen. This period of cohabitation is important to foresee.
Conclusion
In case of dispute, the earn-out clause can therefore be a very useful tool to bring the parties to agree on a firm selling price. But be careful: in trying to avoid a conflict, one might rather see it postponed at a later date if the terms and conditions of this clause are not properly drafted. It is better to be well advised by a lawyer specialized in mergers and acquisitions.
