Earn-out. How 40 percent of a company’s price disappears in the agreement’s definitions

An earn-out is the part of the price that the buyer pays later if the company achieves agreed results. A seller who accepts one takes on something he rarely says out loud. Payment of that part will depend on decisions he no longer makes himself once he has handed over the company.

Four legal decisions by the new owner are enough for the company’s EBITDA to fall from PLN 12 million to PLN 8 million, and for PLN 48 million of the PLN 120 million price to be lost. Nobody breaches the agreement in the process. Whether this money reaches the seller is decided by the agreement’s definitions. Yet the seller usually negotiates only the amount.

The structure itself makes sense for both sides of the deal. The seller believes the company is worth more than the buyer is willing to pay today. The buyer does not want to pay up front for growth he cannot yet see. An earn-out bridges this gap: part of the price at closing, the rest once the agreed results are achieved. It sounds fair, and it often is. The trouble starts after closing, when the number on which the payment depends is already controlled by the buyer.

Control passes at closing

Signing the agreement sets the terms of the sale. Control of the company passes to the buyer on the closing date, for example after clearance from the competition authority. Until that day the seller runs the company, and after it the buyer does. This one change reverses the whole earn-out calculation, because the result on which the payment depends is produced under the new owner.

The new owner has many legal ways to lower this result, and none of them requires bad faith. He can cut the marketing budget because he plans over a longer horizon than the three-year settlement period. He can also charge the company a license fee for the brand or a share of the costs of a shared IT department, and send new contracts to another group company where the margin is higher. From the group’s point of view these are rational decisions. Each one lowers EBITDA, that is, operating profit plus depreciation and amortization. The payment depends on that number. All of them fall within the limits of the agreement, unless the agreement expressly rules them out.

That is why for every earn-out clause I ask one question, which I call the control test. Who steers the result on which the seller’s money depends after closing? If the answer is “the buyer,” and in the sale of a controlling stake this happens very often, the seller should stop treating the earn-out as a bonus. It then works like an option in the buyer’s hands, that is, a right the new owner will exercise or not, depending on his own calculations.

Two sellers, the same structure, different endings

The first negotiated the way most sellers do. He argued hard over the size of the payment and the threshold that had to be exceeded. He got a good amount and signed. Three years later the new owner charged the company with group costs and moved part of its revenue to another company. The result slipped below the threshold, and the payment was lost. Nobody breached the agreement. The seller won a negotiation over an amount he never saw.

The second started with the definitions. He excluded costs imposed by the group from the calculation of the result and froze the accounting policies for the settlement period. He also protected himself in case he was removed from the management board. The agreement left such charges out when calculating EBITDA, so the result on which the payment depended remained protected. The earn-out was paid in full. The fate of both payments was decided by a few clauses that the first seller read too quickly.

I have changed the details so that neither the companies nor the parties can be identified.

Definitions weigh more than the amount

What set the second seller apart from the first comes down to three clauses. At Capital One Advisers we agree them alongside the amount, already in the letter of intent, that is, the preliminary agreement on the main terms of the deal.

The first is the definition of the result itself. EBITDA in the agreement can be a different number from EBITDA in the seller’s presentation. What decides it is which costs may be charged against the result during the settlement period. If the agreement allows the company to be charged with group costs without limit, a threshold that seemed easy suddenly becomes high.

The second is accounting discretion. The same business, accounted for under another, equally permissible accounting policy, produces a different result. Accounting policies decide, among other things, when the company books revenue and what provisions it makes. Without a clause stating that they remain unchanged during the earn-out period, the buyer can shift results between years without breaking any rule. A good agreement also replaces the “all or nothing” principle with a payment proportionate to how much of the plan was achieved. It gives the seller access to the books and refers any dispute over the calculation of the result to an independent auditor for decision.

The third is the rules for the settlement period. Here sellers are often wrong, because they look for protection in the wrong place.

Management board independence does not protect the seller

A seller often imagines that he will protect the earn-out if he keeps influence over the company’s decisions after the sale. The law gives him less here than he thinks.

In a joint-stock company, the general meeting and the supervisory board cannot give the management board binding instructions. In a limited liability company, however, the shareholders can restrict the management board by resolutions, unless the articles of association exclude this. A parent company can also issue binding instructions if it brings the acquired company into a formal group of companies. Above all, though, after the deal the buyer holds the majority of votes, and a member of the management board can be dismissed at any time.

Usually the buyer does not need formal instructions anyway, because he appoints the majority of the management board. On a board with several members, his representative can block a decision of the seller by objecting and force a vote in which the new owner has the upper hand. An investor taking control of a company also rarely agrees to give the seller a veto over day-to-day matters. An agreement on a brand license fee or on head office costs will be signed by a management board chosen by the new owner. The seller will therefore find it hard to enforce any influence over the company’s day-to-day decisions. His protection has to rest on two other things.

The first is firm undertakings by the buyer as a shareholder. The sale agreement binds the buyer directly. It prohibits him from charging the company with group costs above an agreed limit and from moving revenue to other related entities. It also freezes the accounting policies and requires the company to be run as before. If the buyer breaks these prohibitions, the imposed cost or the lost margin is added back to the EBITDA calculation and does not reduce the payment.

The second is the seller’s own seat on the management board for the duration of the earn-out. If the seller stays on the board, he runs the company’s day-to-day work and sees its contracts and books as they happen, although on a board with several members he can be outvoted. The buyer can also dismiss him at any time. That moment therefore has to be guarded in the agreement. Dismissal of the seller from the management board without good cause during the settlement period should trigger two payments at once. The first is an obligation to pay the entire deferred amount immediately. The second is a premium for depriving him of the chance to deliver the plan and fight for the earn-out on his own terms. The first returns what had been agreed anyway. The second compensates for the lost chance of a higher amount, if under the agreement the payment rises with the result. The buyer then faces a real choice. Either he leaves the seller on the management board and lets him watch over the result from the inside, or he dismisses him and immediately pays the entire deferred amount, together with any premium.

What it looks like in numbers

Take a simple deal. The company has no debt and no surplus cash, so the price for the shares equals the value of the business: PLN 120 million. Of this, the buyer pays PLN 72 million at closing, and PLN 48 million, or 40 percent of the price, is the earn-out. The payment is all or nothing. It is due in full only if the company maintains EBITDA at its starting level for three years. On the closing date the company generates PLN 12 million of EBITDA a year. The price of PLN 120 million therefore implies a multiple of ten, justified by the pace of growth the buyer is counting on. The threshold, however, does not require growth. It is enough for the result to hold.

Twelve million of EBITDA, the threshold within reach, the seller at ease. Then the company’s ordinary life within the group begins.

The new owner introduces a license fee for the group brand of 2 percent of revenue and charges the company a share of head office costs. Together that is PLN 2 million a year, so PLN 12 million becomes PLN 10 million. Next he moves two contracts to a sister company, because he can account for them more favorably there. This takes away another PLN 1.5 million of margin, which leaves PLN 8.5 million. Finally he centralizes purchasing in the group and allocates to the company part of the costs of the shared IT department, another PLN 0.5 million. The result falls to PLN 8 million.

The business has not weakened. The same teams serve the same customers. EBITDA as measured for the earn-out, however, has fallen by a third, from PLN 12 million to PLN 8 million, and the threshold has become unreachable. Of the PLN 48 million of deferred price, the seller gets nothing. Each of these decisions on its own was rational and legal. Together they cost him 40 percent of the price.

The seller focused on the amount and agreed to a rigid threshold. The buyer took care of the definitions and judged better what really matters.

Where this argument ends

Not every decision by the buyer that lowers the result is an attempt to avoid the payment. Group charges can be justified, because the company uses a shared brand and shared IT systems. Prohibitions that are too rigid can block an integration from which both sides would gain. A good agreement distinguishes spending that brings the company a real benefit from a fee that only shifts profit within the group. A seller on the management board also has a duty to act loyally toward the company. He cannot raise the result for the purposes of the earn-out at the expense of the company’s future, for example by cutting spending on maintenance or on developing the team.

Nor is an earn-out by nature a trap for the seller. When well structured, it works in favor of both sides. The buyer does not pay up front for growth that does not yet exist. The seller gets a real chance of a higher price, because when ambitious targets are met, the total price can be higher than he would have negotiated for payment in full up front. Both sides then play for the same result.

The heart of the matter

An earn-out is decided in the deal preparation phase. Three years later, when the payment is settled, the parties can only argue about what they wrote into the agreement. At the moment of signing, the seller has either secured the definitions and the rules for the settlement period, or handed control over a large part of the price to someone who has his own interest in keeping the payment as low as possible. The price announced when the deal is signed makes an impression. What counts, however, is the price that reaches the seller’s account after three years under the new owner.

At Capital One Advisers we begin the conversation about an earn-out with the question of what part of the price is worth deferring at all. Advisers answer it in different ways. Some take the view that the amount payable at closing must be enough for the seller on its own, and they treat the earn-out as a bonus. Others accept a larger deferred portion if the agreement protects the result well, because this makes it possible to achieve a higher total price than with payment in full up front. The first approach protects the seller against a loss, the second gives him a chance of getting more.

Service: M&A advisory on a company sale