My friend recently sold a business, but he had a bit of difficulty with an earn out provision after selling it. I am not sure what that means though – I am building my business to sell, but does this mean I will have difficulty selling as well in the future?
Earn out provisions are tricky clauses to get right. They are included as part of the sale and purchase contract between you as the seller, and your buyer, and is just one type of way of structuring a deal when selling. The idea is simple: you receive part of the purchase price after the company has been sold and is dependent on the performance of the company. It’s true to say however, that this is not necessarily going to be right for every transaction, so you may find you do not end up negotiating any earn out provisions as part of the deal.
While in theory it’s a simple concept, i.e. you get more money if the company does well, the reality is that it can vary widely from transaction to transaction and therefore can be a hot topic when negotiating between the parties. It is therefore key to have this dealt with by your legal advisors, in order to avoid issues later down the line.
Earn outs can be beneficial for both sides. A buyer may not have access to full funds, while the seller knows he or she can have further consideration later down the line providing the company performs well. What is key to realise however is that there are no guarantees that that money will be paid – it really is determined by the performance of the company.
Such a position brings up interesting points for negotiation such as:
- Agreeing between the parties how performance is going to be recorded and calculated – for example, what is the exact calculation of profit, what are any relevant targets and are they realistic?
- When and for how long are payments to be made to the buyer for successfully reaching growth and performance targets?
- What is the actual mechanics for measuring performance?
- How are disputes over calculations to be resolved?
- What the buyer is obligated to do during this time, and what events could have a negative impact on the earn-out payments?
The difficulty parties face however, and of course, as your friend discovered, earn-outs mean the parties are tied in together for a certain period of time after the deal has been completed, meaning it doesn’t give a clean break option. This is fine when it goes right and the parties are happy, but often problems occur if the company is not performing as well as expected. However, if proper financial and legal advice is taken from the outset and all the above matters negotiated on throughout, they can work really well, and go a long way to minimising any disputes in the future. The cost may seem significant in the first instance, but will almost always outweigh the cost of disputes in the future.