1 April 2020

What about the earn-out? 

It’s common for sellers and buyers to bridge price expectations for private companies through an ‘earn-out’, with potential earn-out payments sometimes running into the £millions.

Those sellers whose earn-out period ended by December 2019 or January this year will be breathing a huge sigh of relief as they watch the majority of businesses suffering the worst revenue fall off in living memory. For those sellers who are still in an earn-out period or, however unlikely it may be, are considering signing up to an earn-out mechanism, or for buyers who are due to make an earn-out payment, the following advice may be useful.

Buy-side issues

Issue 1: Earn-out payment is due to the sellers but the pressure on cashflow means buyer can’t/won’t pay.

Sellers will want the best chance of receiving as much of the earn-out payment as possible, and may well be open to negotiating a reduced payment or extended payment terms if the only other option is to rank alongside all other creditors in an insolvency process.

If the sellers are not willing to negotiate, and assuming the business is likely to survive in the long term, consider refinancing to cover cashflow until trading conditions improve. We can introduce businesses to different short and longer term sources of finance.

Issue 2: Covid-19 downturn affected trading during the earn-out period and sellers are still working in the business.

If the sellers are key to the continuation of the business, consider how you will keep them motivated in the absence of an earn-out payment. Consider an extension to the earn-out period to cover a return to normal trading in the future.

Issue 3: Earn-out protection in the share purchase agreement (SPA) restricts the buyer from making significant decisions that may be necessary for the business’ survival or the survival of a wider group of companies.

Check your obligations carefully. A well-drafted, negotiated set of earn-out protections should cover situations beyond the parties’ control. Check and understand whether you have agreed to use “best”, “all reasonable”, “all commercially reasonable” or “reasonable” endeavours in agreeing to the earn-out restrictions and obligations – they mean different things and it could be the difference between putting the sellers’ interests ahead of or behind those of the company. We can provide practical advice on how to fit your decision-making into the earn-out protection schedule without risking a seller claim.

Sell-side issues

Issue 1: Earn-out payment is due but buyer doesn’t have enough cash.

Consider whether there is any greater chance of receiving the earn-out payment by pursuing insolvency proceedings. It’s unlikely in today’s circumstances that this would result in full payment. An instalment arrangement (with interest) may be a sensible compromise, or a reduced immediate payment in full and final settlement.

Issue 2: Avoiding a conflict of interest

Where you are a director of the buyer or the target – quite common in private equity backed MBOs – it’s critical for you to consider your directors’ duties at all times. In particular, you must avoid a conflict of interest in demanding payment of an earn-out and/or running the business during the earn-out period. It may be tempting to make decisions which maximise the possibility of reaching earn-out targets, but those decisions could well be reviewed by insolvency practitioners if the company becomes insolvent.

Ask yourself: would I make this decision in the same way if I didn’t have an earn-out?

Issue 3: Earn-out missed because of Covid-19 related downturn

The buyer may be willing to negotiate a lesser figure, a longer earn-out period or payment over time in recognition of extraordinary circumstances affecting businesses everywhere.

If you don’t ask, you’ll never know.

Issue 4: The buyer is ignoring the earn-out protections in the SPA

As with the buy-side issue above, taking action for breach of earn-out protections (such as not dismissing senior employees or making sure the target business has sufficient working capital) will depend on the protections negotiated in the SPA and the basis of any “endeavours” obligations. In its weakest form, a “reasonable endeavours” commitment to do certain things, or refrain from doing those things, will take into account the Covid-19 crisis and that will most likely set a new standard for what is “reasonable”, taking in account all the circumstances.

If you’re concerned about how the business is being run or that the buyer is breaching or is likely to breach the earn-out protection provisions, talk to us as soon as possible. We can sometimes stop problems in their tracks.

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About the Author
Rachel Turner, Partner

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