Clear communication key to successful earn-outs

Using earn-outs
When executed well, earn-outs provide the opportunity for the seller to benefit from strong post-transaction financial performance.  They can also reduce the risk of buyers overpaying based on growth assumptions that do not transpire. Other instances where earn-outs are useful include the following:

• When the buyer is acquiring a business in a new market or industry where future performance is less predictable
• The target business is expected to experience significant growth in the future and the seller wants this to be factored into the price
• It is beneficial to incentivise and retain the expertise of existing management to ensure the future success of the business (to effectively transition intellectual property to the buyer)
• Bridging a value perception gap between the parties, resulting from different expectations of future performance

Frequent causes of earn-out disputes
Earn-out clauses are often given the most attention in the SPA and with good reason. It is difficult to predict all the changes that a business will go through post-deal, and there could be expectations from the buyer to benefit from any improvements achieved by the business. After all, if they have ‘earned’ the uplift in performance, they may not necessarily believe they should share this upside with the seller.

Not managing expectations leaves the door open for future disputes, so earn-out targets and associated clauses in the SPA need to be drafted carefully. If, for example, there is ambiguity in the earn-out targets set, this can influence decisions made by the buyers’ management that benefit them financially, but do not necessarily enhance the acquired business (for example, adding additional overheads to the acquired entity relating to a group structure), and penalises the seller.

Another situation that can create conflict is if the financial results of the business during the earn-out period are close to the upper or lower thresholds within which an earn-out amount is payable, particularly if a multiple is to be applied in arriving at the price adjustment; this is likely to lead to close scrutiny of the earn-out accounts and potentially manipulation and a dispute.

Integration post-deal with other businesses or entities in the buyer’s group, or changes to systems and personnel, can make comparable performances more difficult to measure. For example, we were asked to advise a new client that wanted to add additional sales resource to the business that it acquired post-transaction, which was aimed at driving long-term growth. However, the seller had an issue with this as the payback period did not occur during the earn-out period. In this case, the seller had not been properly advised and our client could justify its position and accordingly hired the additional sales resource. However, the whole dispute could possibly have been avoided if more diligence had been paid to the mechanisms of the earn-out.

How to avoid disputes
It is unrealistic to mitigate all risks of disputes arising from an earn-out. However, many can be avoided by ensuring the earn-out provisions in the SPA are clear and unambiguous.

There are simple guidelines that can be followed to improve clarity during this process starting with clear definitions for what should be included/excluded; ideally, these should be illustrated in a pro forma earn-out schedule calculation. Elements that need to be covered include clear accounting policies dealing with judgmental areas open to interpretation and manipulation, and a clear reference point for measuring earn-out results that are consistent with how future maintainable earnings (the basis of how the business was valued) was calculated. Referring to an historical set of audited accounts or diligence management accounts are good places to start.

We have also seen ways in which these risks can be mitigated by changing the level at which the earn-out is calculated (for example gross profit vs. EBITDA) or by agreeing a cap on overhead costs attributed to the acquired entity post-transaction during the earn-out period.  If the buyer does anticipate structural changes to the business, such as restructuring of personnel or merger with other businesses, these should be provided for in the earn-out clause of the SPA.

How to resolve disputes
Including directions in the SPA for the earn-out process to be taken is an effective way to ensure disputes are resolved efficiently. The preparing party (typically the buyer) should provide draft directions in an agreed format within an agreed timeframe after the end of the earn-out period. Following this, the reviewing party (typically the seller) should have an agreed length of time to either submit a notice of dispute (setting out in reasonable detail the reasons for its objections and the adjustments it proposes) or to accept the draft earn-out accounts as final and binding. In the case of a notice of dispute being served, the parties have an agreed timeframe to seek in good faith to resolve the matters between them. If finding a resolution fails within the agreed timeframe, any remaining issues should be referred to an independent accountant for expert determination.

As well as negotiating earn-out clauses for clients, we are often asked for our expert opinion for earn-out disputes. Resolving these often comes down to the SPA definition of key terms such as “normalised earnings” and a comparison between accounting treatment pre and post-deal.

Earn-outs do not need to lead to a dispute. With careful planning and clear communication from the outset, a smooth transition post-deal can be achieved.

To read more about earn-outs, download our report, ‘Earn-outs: How to avoid pitfalls and protect value’.

Russell Moore
National Managing Partner
Grant Thornton New Zealand
T: +64 9 922 1237
E: [email protected]