Earn-Out Pricing Mechanisms a timely update

This isn’t the first time that I’ve written about earn-outs, but the recent high profile news of the actor, Ryan Reynolds selling his shares in drinks company Aviation Gin, to Diageo and his subsequent press release where (with tongue firmly in cheek) he admits to not appreciating how the earn-out in his own deal actually works, serves as a good excuse to look into this area again. Of course, this is also a key current trend for corporate advisers bearing in mind today’s global M&A market where buyers will be looking to insure the risk of continuing trading uncertainty linked to Covid-19 by pushing for conditional deferred consideration structures.

On this basis, and in order to avoid the need to “do a Reynolds” and send out an email of apology to your loved ones who you’ve insulted when misunderstanding how much cash you’re actually taking home on day one of your sale; any business owner looking to exit is well advised to gain an understanding of this key pricing mechanism…

The Fundamentals

An earn-out mechanism will require all or some of the selling shareholders of a target company to continue their work and involvement in it following completion of its sale to the buyer. Although the sellers will very likely receive a day one payment for their shares, they will also have the ability to earn further amounts depending on whether or not the target company hits certain financial trading targets in a post-completion period, somewhere typically between two and five years. The sellers will be required to contribute to the target company’s performance in this time although such level of involvement will obviously vary depending on the nature of the transaction itself and the profile of the sellers and buyer involved.

The Negotiation

Earn-outs can potentially be complicated and time consuming to negotiate as the two sides need to reach agreement on key metrics such as the amount and calculation of the earn-out target number itself of course. Earn-outs can be measured against an array of financial indicators and so the parties will need to establish exactly what the success criteria looks like, from profits in respect of key product lines that the sellers are personally responsible through to overall turnover of a business for example. Clearly other key points to agree will be the payment timetable and length of the earn-out period (i.e. for how long revenue earned post-completion will qualify as contributing towards the earn-out target number) and the scope of the role that the founders will play in continuing to run the business during the earn-out period and the level of checks and balances placed on them by the new owners during such time.

The Nuanced bit

Whilst both parties will of course, have an overriding shared interest in the on-going success of the business, there is a slightly more nuanced distinction between the agendas of the two sides going forwards that will need to be considered and a position ultimately agreed upon. Clearly, the sellers will want to ensure that they are not unfairly prevented from being able to take commercial decisions for the business which will hopefully maximise the potential of their earn-out and equally, they will want to ensure that restrictions are placed on the new owner unreasonably transferring out revenue generating assets for the sole purpose of prejudicing the earn-out numbers.

However, on the other side of the negotiation table, the new owner will want to be protected to ensure that it retains ultimate autonomy over how its new company is being run in a way that reflects its own principles and overall business model and in particular, is set up with a focus on longer term growth prospects over and above any short-termism agenda put in place by sellers who are focussed on securing a high value earn-out payment covering the relevant shorter trading period.

Final Thoughts

Despite the required detail, if both sides are able to take a sensible and commercial approach to discussions around an earn-out arrangement, it can provide an efficient and financially compelling exit platform for founding shareholders who are prepared to remain on board with their business and work with the new owners with the aim of hitting financial performance targets in the immediate future which will of course, be to everyone’s benefit. Current market indications are that the money is still there to do deals but sellers previously looking to do a George Clooney and sail off into the sunset on day one, may need to adapt to the current climate and look to Ryan Reynolds as inspiration for staying on with their business post-sale in order to ultimately achieve the highest value return.