Reed Smith Client Alert

Key takeaways

  • Earn-outs are increasingly prevalent in mid-market M&A to bridge the valuation gap in the current economic climate.
  • If structured appropriately, earn-outs can be highly effective so involve financial and tax specialists early in the transaction.
  • Consider if there are appropriate objective performance metrics in the context of the business and the buyer’s plans for operating the business post-completion.
  • Earn-outs are complex and increase the potential for disputes so be clear and objective, include worked examples and have a robust dispute resolution mechanism.

Once reserved predominantly for sectors with high growth potential such as tech and health care, in light of the current uncertain economic landscape, buyers and sellers are increasingly turning to earn-outs in mid-market M&A deals as a way to bridge the gap between buyer and seller valuation expectations and get deals over the line.

What is an earn-out?

An earn-out is a pricing mechanism where some of the price is contingent and only payable post-completion if certain financial targets or milestones are achieved.

Key features of an earn-out

There is no “market-standard” approach to earn-outs. An earn-out is a flexible tool that allows a buyer and seller to agree a mechanism that works for the size and nature of the business on a deal-by-deal basis. However, the following key points should be considered when structuring an earn-out:

  • Performance metrics: An earn-out will include a performance metric which, if satisfied, will result in the payment of additional consideration to the seller. The metric is typically financial – such as EBITDA, revenue or sales targets – but can also include other, non-financial metrics that are appropriate to the specific business, such as client retention or product milestones. In terms of financial metrics, EBITDA is most common and will often be the buyer’s preference on the basis that it is the most reliable metric for determining the profitability of a business. However, EBITDA is open to manipulation. For example, a buyer might be incentivised to front-load capital expenditure to lower EBITDA during the earn-out period and (hopefully) increase EBITDA afterwards. This risk can be mitigated by agreeing a budget at the outset. Financial metrics based on revenue or sales targets are considered less open to manipulation, so sellers often prefer them.