Business Law
Earn-out - an agreement
to fight about the price later?
In share purchase agreements it is not unusual to let part of the price be dependent on future events. However the definition, calculations and the control of such events may turn out to be the recipe for dispute later on.
Pricing of private companies - the earn-out solution
When negotiating the purchase of a private company, the subject of price - what the sellers are to get for their shares in the company - will often be the key issue when the seller and buyer are trying to reach signing.
Most typically the seller will argue for a high value as to get as much out of the transaction as possible including with a view point of what (fantastic) forecast to apply to the business long-term profitability. Hence there are typically intense negotiations.
A way to mitigate a case where the sellers and the buyer have different view points will be for the buyer to accept to pay a higher price, but ONLY if part of that payment is deferred to the future and made dependent on specific conditions being met by the company - making the sellers walk the talk.
The earn-out
The earn-out constitutes a part (or the whole) of the share purchase price. It will not be paid upon closing of the deal, it will instead be paid at a one or several points in time in the future dependent on certain events/results being achieved by the target company (i.e. the company being bought).
Earn-out examples
A typical earn-out could be dependent on the company´s EBITDA. For example making the earn-out dependent on the company reaching a positive EBITDA the next subsequent two fiscal years after the transaction.
Example
Fixed price: 10,000,000 SEK
Earn-out 1: 4,000,000 SEK
Earn-out 2: 8,000,000 SEK
The earn-out of 4 MSEK will be paid out if the target company has a positive EBITDA the following fiscal year, and 8 MSEK will be paid out if the target company´s EBITDA increases with at least a hundred MSEK the subsequent accounting year (i.e. the second fiscal year after the transaction).
Result:
This means that the Sellers could get 10,000,000 SEK only if the earn-out is not reached and 22,000,000 SEK if the two earn-outs are reached. That´s a huge difference in what the Sellers will get.
So why the fights over earn-outs?
Basically it could be tempting for a party - BOTH the seller and the buyer - to, after signing, be creative in order to either reach the earn-out or to not reach the earn-out.
This is in particular the case for the buyer who will control the company’s operations and accounting after closing. For example, if revenue could be significantly increased by bringing on a new customer at “normal price” already in the first year after the transaction, but the buyer prefers to keep the 12.000.000 earn-out payment the buyer will want to keep the EBITDA low. Hence, the buyer might offer the new customer a substantial discount the first two years with a trade-off for a 10-year contract, where they will catch up on the discount over time – and saving the earn-out of 12 MSEK on top of that. Or there might be a case where substantial costs are front-loaded in order to reduce profits the first years after the transaction.
Conclusion
Earn-outs can be a great way to find a more fair price for the company given that you connect the price to how the company actually evolves instead of guessing. It can be a way to reach an agreement at all. However, it is generally also the clause in a share purchase agreement that results in the most legal disputes given the many ways the financial statements of the company can come into question, and hence also the calculation of the earn-out to be paid. And there is typically a massive incentive for both parties to push their points. So make sure that the earn-out is crafted to be as clearly as possible, and to prevent any creative solutions from either party.
Stockholm, 15 May 2024
Author: Katarina Strandberg
Pricing of private companies - the earn-out solution
When negotiating the purchase of a private company, the subject of price - what the sellers are to get for their shares in the company - will often be the key issue when the seller and buyer are trying to reach signing.
Most typically the seller will argue for a high value as to get as much out of the transaction as possible including with a view point of what (fantastic) forecast to apply to the business long-term profitability. Hence there are typically intense negotiations.
A way to mitigate a case where the sellers and the buyer have different view points will be for the buyer to accept to pay a higher price, but ONLY if part of that payment is deferred to the future and made dependent on specific conditions being met by the company - making the sellers walk the talk.
The earn-out
The earn-out constitutes a part (or the whole) of the share purchase price. It will not be paid upon closing of the deal, it will instead be paid at a one or several points in time in the future dependent on certain events/results being achieved by the target company (i.e. the company being bought).
Earn-out examples
A typical earn-out could be dependent on the company´s EBITDA. For example making the earn-out dependent on the company reaching a positive EBITDA the next subsequent two fiscal years after the transaction.
Example
Fixed price: 10,000,000 SEK
Earn-out 1: 4,000,000 SEK
Earn-out 2: 8,000,000 SEK
The earn-out of 4 MSEK will be paid out if the target company has a positive EBITDA the following fiscal year, and 8 MSEK will be paid out if the target company´s EBITDA increases with at least a hundred MSEK the subsequent accounting year (i.e. the second fiscal year after the transaction).
Result:
This means that the Sellers could get 10,000,000 SEK only if the earn-out is not reached and 22,000,000 SEK if the two earn-outs are reached. That´s a huge difference in what the Sellers will get.
So why the fights over earn-outs?
Basically it could be tempting for a party - BOTH the seller and the buyer - to, after signing, be creative in order to either reach the earn-out or to not reach the earn-out.
This is in particular the case for the buyer who will control the company’s operations and accounting after closing. For example, if revenue could be significantly increased by bringing on a new customer at “normal price” already in the first year after the transaction, but the buyer prefers to keep the 12.000.000 earn-out payment the buyer will want to keep the EBITDA low. Hence, the buyer might offer the new customer a substantial discount the first two years with a trade-off for a 10-year contract, where they will catch up on the discount over time – and saving the earn-out of 12 MSEK on top of that. Or there might be a case where substantial costs are front-loaded in order to reduce profits the first years after the transaction.
Conclusion
Earn-outs can be a great way to find a more fair price for the company given that you connect the price to how the company actually evolves instead of guessing. It can be a way to reach an agreement at all. However, it is generally also the clause in a share purchase agreement that results in the most legal disputes given the many ways the financial statements of the company can come into question, and hence also the calculation of the earn-out to be paid. And there is typically a massive incentive for both parties to push their points. So make sure that the earn-out is crafted to be as clearly as possible, and to prevent any creative solutions from either party.
Stockholm, 15 May 2024
Author: Katarina Strandberg