Deferred payments in sales contracts. The specific case of earn out
Earn out is a very interesting and useful mechanism in M&A processes as it facilitates price negotiation.
The earn-out in M&A refers to a contractual agreement within the sale and purchase agreement (SPA), where it is established that the buyer divides the price of the operation in two moments. In addition to paying a part of the price at the signing of the agreement, a variable amount(earn-out) is allocated depending on the fulfilment of certain objectives, normally sales and/or EBITDA for the year or years following the signing. This practice is often used when the price expectations between buyer and seller are far apart. It is a good practice to obtain a higher price. It is also used in complex market times when there is high uncertainty in the sector of activity. It is also often a good tool when the SPA establishes that the ownership and/or management team must remain linked to the company for a certain minimum period of time. Normally the seller wants to receive the maximum amount at the signing of the contract, but if an earn out is agreed, the following aspects should be taken into account:
- The objectives to be achieved must be reasonable and in line with the company’s growth.
- Include the article “good faith and fair dealing” in the contract. At a minimum, the seller will require the buyer to operate the acquired business in good faith and treat it fairly. It is usual to agree on a Business Plan and its implementation plan. It is highly recommended to establish, if they exist, the synergies to be applied.
- Avoid making the earn-out an all-or-nothing deal. In such a way that it offers the possibility of establishing a downward or upward escalation, both if it is not achieved in its entirety and if the objective is exceeded.
- It is essential to establish the necessary mechanisms in case of discrepancies in the calculation of the earn-out. It is advisable to involve an auditor external to the parties in the event of differences in the calculation of the results.
- Carefully study the tax aspects related to the deferred payment.
The earn out payment structure is becoming established as a common mechanism in sale and purchase processes and therefore the need for clear and unambiguous wording in the SPA is vital and fundamental to the success of an M&A transaction.