Earn Outs - the way forward ?

Earn outs are becoming more and more popular as a structure for the sale of shares in a company.

Rather than handing over an all-cash, up front payment for an acquisition, the buyer offers a down payment, agreeing to follow this with instalment payments at later dates. The catch is that if the acquired business fails to raise earnings to pre-decided benchmarks after the acquisition, the purchaser pays nothing more for the business than the initial sum.

Theoretically both parties in the earn-out benefit - the purchaser makes the vendor put their money where their mouth is, while the vendor can almost always expect a higher price than they would get for an up-front payment. Indeed the multiples that come into play in an earn-out can often make the deal structure preferable to the vendor.

The trade off is the matching of the current value with the potential value that you could achieve through an earn out. There are very significant multiples that a purchaser can expect to achieve through an earn-out and pay the same in cash up-front as they would have seen the earnings being achieved.

But tensions can arise. In an earn out, it is usual for the vendor to remain a part of the target business until the earn-out is complete to drive the company's growth and conflicts can often occur between vendor and purchaser.

The term of an earn-out is a crucial area of negotiation as for the vendor it is vital that they remain masters of their own destiny. Therefore if they're entitled to a payment based on the performance of the business over the next three to five years, they will want to see that they can manage the business in a way that they want, that they will have adequate working capital and that the business won't be pillaged in order to meet other needs of the purchaser group.

From the purchaser's point of view it will need to ensure that the business is being run in a manner that it is happy with, having committed its own capital to the up-front sum. Inevitably there will be a tension.

Most areas of contention centre around the finances of a business. The vendor will want maximum control and the purchaser will generally accept that there should be a degree of ring fencing in control, but want to be able to step in if they think the thing is going off the rails.

But these tensions must be put aside for the deal to work. An earn-out will only run smoothly if each party is able to see the other's point of view and reach a compromise.

An earn-out will work for both sides providing each is prepared to be practical and commercial about the way it is implemented. If the vendor expects to be able to keep the purchaser completely at arms length and uninformed, then the relationship will break down. If that happens the performance of the business will be impaired and the earn-out will not work.

Technicalities of technology

The time period over which an earn-out runs can vary from a matter of months to as much as five years in some cases. But however long the deal lasts, it is important to ensure both parties have a clear understanding of terms and conditions from the start.

Linkage to turnover, net profit etc calls for careful definition of those terms for the purposes of an earn-out. This demands a detailed description of accounting policies and methods of measurement such as deductions allowable in calculating profit, the description and extent of management charges which may be imposed by the new business owners and the point in time at which revenue is recognised.

The earn-out can be suitable for deals in all sectors but is proving particularly common in the technology sector.

Despite the current tech sector recession, many owner managers have an inflated view of the value of their business but in the current market, potential purchasers are unwilling to match their expectations.

So the earn-out is likely to remain a feature of acquisitions in the IT sector for the foreseeable future. But vendors should realise that the full deferred amount might not be paid, and that efforts should be concentrated on grooming a business for sale and ensuring that as mush consideration is received up front as possible.