Welcome to MJ Hudson’s monthly On Target, where you’ll find useful tips and insights to ease you through your M&A transactions. This month we focus on earn-outs, which are a hot topic in the current M&A market as a useful tool to bridge valuation gaps.
A seller will want to know that the company won’t change the way the business operates in order to avoid an earn-out payment, so will ask for contractual assurances (usually consent rights) relating to the conduct of the target business after completion. The guiding concept here should be proportionality; it’s not in the interest of any of the parties to hamper the operation of the business or its growth. A basic level of protection is justifiable to deny the buyer an easy ‘work-around’, but the parties should view earn-out protections as an exercise in aligning interests. It follows that earn-out protections should be lighter where the beneficiaries of the earn-out retain a significant stake or involvement in the target business.
If the potential earn-out is significant, the seller might request security for the earn-out payments. A buyer should consider whether it would agree to this, and in what form. Examples include (1) parent guarantee, particularly common where the buyer is a shell company, (2) simple cash escrow, (2) third party bank guarantee (can be costly), (4) charge over the buyer’s assets (difficult – might already be charged to a bank), and (5) charge over all or some of the shares being sold (not appealing, and the shares may already be charged).
This is a tricky one. A management seller (i.e. director or employee who is selling shares but staying in post) will want to know that dismissing him/her does not give the buyer a free pass to avoid paying the earn-out. But equally a buyer won’t want to pay the earn-out to a management seller who misbehaves/joins a competitor. Concepts of good/bad leaver come in handy, and should feed into how the earn-out is to be valued. Layered on top of this is a tax issue (see UK tax issues below).
Earn-outs usually have a short life (a few years maximum), so it’s tempting to assume any sale or exit is well beyond that horizon. But Murphy’s law teaches us to prepare for the unexpected, so think through some scenarios. The new shareholders will want freedom to sell, and to have a clean break (free of legacy earn-outs) when they do sell. As an earn-out beneficiary, you wouldn’t want to be left empty-handed while the current shareholders are enjoying their sale proceeds. For these reasons it’s best to establish upfront what are the consequences for the earn-out of a sale (whole or partial) or other exit event (e.g. asset sale, IPO) before the earn-out period is complete. If a payout is to be accelerated on exit, specify how the value of the earn-out will be calculated (buyers won’t want the growth assumptions to be too generous!) and cross-refer to the standard earn-out dispute resolution procedure (see below), just in case…
A right to set-off earn-out payments against warranty claims is one of the most fraught SPA negotiation topics. A seller might see this as an attempt to introduce security for warranty claims by the back door. The buyer will want to avoid the pain and embarrassment of paying under an earn-out despite discovering a problem in the company. The solution usually lies in setting an appropriate threshold for the withholding of earn-out payments, e.g. warranty claims to be sufficiently well formed and meritorious (backed by a third party opinion?) before the set-off right can be invoked. An escrow arrangement might also be used to ‘safeguard’ withheld earn-out payments until the warranty claims are settled.
Combine high cash upsides with potentially complex drafting, and you have a recipe for future disagreement. It’s only prudent to prepare for the worst, so consider how disputes can be resolved swiftly and with minimal cost. Allow plenty of time for the parties to discuss differences before involving costly third parties, but then be clear on the process to resolve intractable disputes. Typically an independent accountant will serve as the arbitrator. Ensure the SPA addresses how and when the parties will make representations to the arbitrator, how fees are allocated and the status of his/her determination (e.g. is it binding, can it be challenged?)
Earn-out structures can vary widely, but typically involve one or more deferred (i.e. post-completion) payments that are dependent upon achievement of certain business targets within a specified timeframe. The key is to focus on the behaviour the earn-out is designed to reward. For example, are you encouraging the take-on of new customers, revenue growth from a new business line, launch of a product, achievement of a milestone? The simpler the formulation, the easier it will be to negotiate, and the lower the risk of subsequent dispute. Once drafted, get your accountants to review the provisions. Always ask if they have seen any simpler methods of achieving the same result.
A classic earn-out is calculated by reference to a financial metric such as profits (EBITDA-based). Typically this will be a read-out from audited accounts, but it may be that special purpose accounts are required (e.g. where the measurement periods are not in line with the company’s financial year). Key questions: who is preparing the accounts? When will the other party have the opportunity to review and comment on them? Does silence constitute acceptance?
However transparent you feel the metric is, and however clear the drafting may be (at least at first!), a string of “if”s, “but”s, “and”s and “or”s can easily allow more than one interpretation of a given set of circumstances. Avoid that potential confusion by complementing the long-form drafting with one or more worked examples, ideally addressing what the parties consider the most likely turn of events.
Earn-outs can be a minefield when it comes to tax, so seek advice whether you are on the sell- or buy-side. In particular, if you are a management seller you will want to ensure that the earn-out is not too closely linked to your employment status, such that it could be viewed for tax purposes as employment-related income rather than a deferred capital gain on the sale of shares. This backfires on the employing company, too, as it would be liable to pay employer national insurance contributions on the “income”. On the buy-side, don’t forget that stamp duty can also be payable up front on the potential earn-out amount, whether or not an earn-out payment is ever made. If the earn-out anchors the payment at any particular level (e.g. a cap, or a floor), stamp duty would be due on the highest of such amounts. Only where the earn-out amount is wholly unascertainable at completion will be no charge on that amount.
Is this brief too brief? Want to know more about earn-out provisions in M&A transactions? (of course you do) Expert legal advice is on hand from MJ Hudson’s M&A team. Just contact any of the On Target team (details below) or your usual MJ Hudson M&A contact, and we’ll gladly help.
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MJ Hudson advised IPAN Services GmbH (a manager / administrator of intellectual property portfolios, backed by Warburg Pincus) on its acquisition of IPSS Europe (a provider of IP software solutions).
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