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Why do earn out clauses often create conflict or end up in court?

By Lauren

How do you value your business when you’re selling it?  In recent years there seems to be more significant differences in expectation of valuation between buyer and seller, and increasingly the

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Earn-out clause has been used as an appropriate way to bridge this gap. The clause basically retains interest and motivation for the seller by holding back a portion of the sale price until certain performance criteria are met, and minimises risk to the buyer of overpaying for a business that doesn’t perform as well as its previous owners say it will.

If it is planned and executed well then the buyer can gain more than originally envisaged, but it is full of risk for the selling entrepreneur and conflicts are almost inevitable.

So what’s the problem?

You might base the sale price of the business on an assumed level of financial performance over the next 24 months, but the seller is cautious and insists on part of the value being deferred and wrapped up into an Earn-out clause. The seller is paid the majority of the agreed value as soon as the sale agreement closes, with a future payment to be made when performance targets are achieved. This might be a single target or an amount released at 12 months and at 24 months, or based on a combination of various targets. It will typically run for either one or two years. In theory, the buyer is creating a significant incentive for the seller to continue to work hard long after the deal is done. On the face of it that looks straightforward but here are some of the common reasons why it can be more problematic.

  • Over-valuing Future Growth
    There will always be the temptation for an optimistic assessment of future growth used by the seller to try to push up the overall value and hence the up-front consideration, which is only going to make the Earn-out harder to achieve. Sometimes the seller adopts the view that if the up front is significant enough then he may discount the Earn-out (‘if I get it, fine, if not I’ve made a lot up front….’). That might be ok for the seller if they have a short term expectation of staying with the acquired business, but it doesn’t help the buyer and will only cause friction when targets are missed
  • New Factors Impacting Profitability or Sales
    Usually the achievement or not of an Earn-out is measured by sales or profitability. When the two businesses are merged its frequently very difficult to ensure that what was easy to measure in one business entity remains easy to measure in a combined business. Costs may be attributed in different ways, the sales teams efforts are diluted because they’re working on different products, pricing strategies change and priorities move. All this causes confusion and lack of clarity and visibility on the original Earn-out targets.
  • Motivation Shifts
    However carefully the agreement is worded to protect the pre-existing environment, practicalities and motivation of the seller’s management team often becomes a challenge. Many of them may have been rewarded in some form via the sale proceeds and may have received a significant financial windfall. The loyalty they had to a previous business may not remain when their reporting lines change and they work for different people, in a different culture with different colleagues, maybe even in a different location or office. If your top salesman for the last two years doesn’t want to travel 30 minutes further than before and can’t get on with his or her new boss, then they may not stay for long, leaving your previously achievable targets looking more aspirational than realistic.
  • Conflicting Goals
    In a different management structure the seller’s team may not be in a position to make decisions on the direction/strategy of the business, which may easily impact on the achievability of targets that are set in the sale agreement. A different management team may have conflicting goals.
  • Spending Changes
    The seller may well decide to reduce staff numbers in critical areas such as R&D or sales, which would clearly make it much harder to achieve targets. The seller might want the buyer to covenant that they would not make such actions; along with other such as commitment not to reduce marketing spend.

Unfortunately, the whole area of Earn-outs has lent itself to litigation. Sellers often claim that the buyers prevented predicted sales and/or profitability from being met and buyers frequently claim that the Earn-out targets have not been achieved. A well-crafted and thought through Earn-out clause can minimise potentially expensive legal costs and maximise the likelihood of achieving full value for your business.

This is one place where a bit of careful planning and advice can save a lot of trouble and bring great rewards.

For more expert advice on Earn-Out agreements or to find a part-time financial director for your business contact Chris Chapman by email at: chris.chapman@lgbusinessadvisors.co.uk

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