We would like to ensure that you are still receiving content that you find useful – please confirm that you would like to continue to receive ILO newsletters.
26 September 2018
What is an earn-out?
Why use an earn-out?
Advantages of an earn-out
Disadvantages of an earn-out
Key issues to consider
It is not always possible for a buyer to meet a seller's valuation expectations, especially when the seller is seeking upfront value for, among other things, expected rather than actual revenue or profit. In these circumstances, the buyer and seller may attempt to bridge the gap and agree the terms of an earn-out.
Under a typical earn-out structure for a private M&A transaction, the buyer will make an initial payment of consideration at completion and one or more deferred contingent payments over a specified period following completion calculated by reference to the target's performance during that period.
Earn-outs are frequently based on the target's profits over the earn-out period, but it is also possible to link the earn-out to turnover, net assets or any other financial or non-financial measure that the parties consider appropriate to a particular transaction.
A buyer and seller may be unable to agree on the value of a target where it lacks a track record in its performance. Particularly where the parties see significant value in the target's growth potential, an earn-out can bridge the valuation gap by facilitating a more accurate valuation based in part on actual future performance, rather than past or predicted future performance.
In some transactions, the continued involvement of target management after completion is important to ensure the future success of the acquired business. Where this is the case, an earn-out could be used as a mechanism to retain and incentivise them to maximise the target's profitability.
An earn-out offers the following advantages to the seller:
An earn-out offers the following advantages to the buyer:
The seller is unable to have a 'clean-break' after completion: it will remain involved in the target business, with no certainty as to the level of consideration that it can expect to receive. Similarly, the buyer will be constrained under the transaction documents as to what it can and cannot do with the target during the earn-out period.
It is difficult to predict the operational aspects of merging two businesses, which means that earn-outs terms are often unclear or do not provide for particular circumstances. A lack of clarity in drafting the earn-out terms can lead to disputes in the future and an unfair outcome for one of the parties.
There are a number of points to consider when drafting and negotiating an earn-out provision:
For further information on this topic please contact Will Pearce or William Tong at Davis Polk & Wardwell London LLP by telephone (+44 20 7418 1300) or email (email@example.com or firstname.lastname@example.org). The Davis Polk & Wardwell website can be accessed at www.davispolk.com.
The materials contained on this website are for general information purposes only and are subject to the disclaimer.
ILO is a premium online legal update service for major companies and law firms worldwide. In-house corporate counsel and other users of legal services, as well as law firm partners, qualify for a free subscription.