The concept of an earn-out is very simple, yet its proper execution is fiendishly difficult. An earn-out is a transaction where at least a portion of proceeds is paid after closing, in a manner that depends on the performance of the acquired company, judged most likely by its earnings.

Often earn-outs are used in owner-managed companies and they generally require that the sellers remain in the management of the company in question to ensure that performance targets and a smooth transition are achieved. Earn-outs are becoming increasingly popular in Central Europe.

What gives rise to earn-outs? Simply put, the owners of companies usually have more confidence in the future performance of their companies than prospective buyers do. This is usual, because sellers tend to have an emotional attachment to their businesses, whereas buyers tend to place more emphasis on possible risks associated with an acquisition.
The discrepancy may sometimes be quite wide, resulting in a valuation deadlock.

The buyer may then graciously agree to break the standstill by improving an initially conservative offer, but on condition that the business plan or level of performance portrayed by the seller materialises. It is a perfectly natural reaction for an investor or buyer to decide to share the upside with the seller, as it creates strong motivation for the selling shareholders to remain involved and maximise the performance of the company. This helps minimise transition risk for the buyer.

Yet the implementation of earn-outs remain devilishly difficult, primarily because of five factors.

First, setting the performance benchmarks that should be achieved is tricky. This includes determining whether the earn-out should be tied to revenue, operating margins, profit, or a combination of these benchmarks. The sellers should have an excellent business plan or budget that gives a relatively accurate estimate of future performance, or else the earn-out can become meaningless. Establishing performance benchmarks can be the subject of protracted negotiations, with each change in benchmark potentially impacting on valuation.

Second, there are issues of control. Compensation of the sellers is tied to performance, but under earn-outs, operating control is usually ceded to buyers. Hence, there must be an elaborate system of checks and balances, usually in the form of veto rights, that give at least a degree of operational autonomy to the sellers, who remain in management. They would be foolish to accept deferred compensation if they had no control over the conditions in which the earn-out might be achieved.

Third, it may be difficult to accommodate unanticipated events during the earn-out period, such as what happens if the business plan changes for whatever reason, or if an unforeseen capital injection is required, or if there is a force majeure occurrence? It is simply impossible to anticipate every eventuality in a contract.

Fourth, it is difficult to account for the synergies between the buyer and the seller’s company, which raises questions like what happens if the buyer brings new orders to the sellers’ company? The buyer might feel that the seller is achieving a windfall that benchmarks are being achieved even if the seller is delivering less than promised. These issues must be carefully discussed, as it is important to avoid misunderstandings.

Lastly, sellers will typically want to protect themselves against fraudulent or arbitrary actions by buyers aimed at shortchanging them on their earn-out proceeds. As with any form of deferred compensation, there may be temptation on the part of the buyers to find a justified or unjustified pretext for deducting from those proceeds.

As a rule, drafting a sale and purchase agreement requires a high-degree of legal sophistication; drafting an earn-out takes the level of sophistication even higher. Legal fees may increase due to a high number of hours as well as higher than normal billing rates for top-notch legal counsel.

However, even the best-laid plans may go awry. For example, those sellers who negotiated an earn-out a year ago will need to work exceedingly hard to achieve targets that were established before the worst of the financial crisis arose.

As the reader has no doubt discerned, earn-outs are not for neophytes: both buyer and seller should have at least one or two people on their respective teams who have structured at least half a dozen earn-outs. While there is enormous potential to create a genuinely "win-win" solution for both buyer and seller, there is also potential for disaster. Earn-outs deserve serious consideration when structuring transactions.  

*Les Nemethy is the chief executive officer of Euro-Phoenix Financial Advisors Ltd. (www.europhoenix.com), a Central European corporate finance company focused on mergers and acquisitions.