"Earn-out" mechanisms in business purchase agreements

When buying a company, the buyer assumes that he will benefit from the company's future cash flow. This cash flow forms the basis for the buyer's valuation of the company and therefore the determination of the purchase price.

Buyer and seller may have different perceptions of what the future cash flow will be and therefore also different perceptions of the company's value at the time of the transaction. An "earn-out" mechanism can bridge the gap between buyer's and seller's different perceptions.

Earn-out is a mechanism where part of the purchase price is paid to the seller after the buyer has taken over the company. Such future payment depends on the company achieving agreed conditions or milestones within defined deadlines, such as turnover, profit, the granting of a (public or private) license, the outcome of a legal dispute, the conclusion of a contract with a customer or similar.

If one or more of the sellers are employees of the company, the earn-out mechanism may motivate them to ensure that the company achieves the objectives that have been agreed with the buyer. Seen from the buyer's perspective, earn-out can represent security that he pays for what he gets and that key people in the company will remain in their roles, at least during a transition phase. For the earn-out mechanism to have the desired effect, it is important that the objectives are realistic and measurable.

In order to safeguard the interests of both buyer and seller, earn-out mechanisms require more detailed regulation in the purchase contract. In practice, the earn-out mechanisms often grow rapidly in scope and complexity during the negotiations. Topics that the parties regularly discuss when earn-out is relevant are typically:

• conditions for obtaining the right to earn-out (turnover, profit, margin, important contract with a customer or other);
• the calculation method to determine whether the conditions have been met (unique description creates predictability and reduces the risk of disputes between the parties);
• the length of the earn-out period(s);
• the extent to which the buyer can make changes to the company's operations that may affect the size of the earn-out (or whether the company in the earn-out period will only be run in the same way as before the buyer's takeover);
• whether, and possibly to what extent, the buyer can charge the company for consultative assistance from the buyer, including group costs, during the earn-out period;
• whether the buyer's added turnover to the company is to be included in the calculation of earn-out;
• whether any (cost) synergy effects between the buyer (or the buyer's group companies) and the company shall benefit the seller in whole or in part when calculating the earn-out (provided that such synergy effects impact the calculation model);
• any prohibitions on the buyer making "structural" changes to the company during the earn-out period, such as de-merger and merger, liquidation, sale or purchase of parts of the company's business, etc.;
• procedures in case of disagreement or dispute regarding determination of the earn-out;
• seller's information rights regarding the company's business during the earn-out period; and
• seller's role in the company during the earn-out period (employee, consultant, board member, observer or similar).

Often, the seller's eventual right to earn-out will depend on circumstances over which the seller has no or limited influence. The buyer, for his part, as owner of the company, will have a number of opportunities to influence whether the conditions for earn-out are achieved. The earn-out provisions must therefore be designed so that the interests of both parties are safeguarded, including that the rights and obligations of the parties in the earn-out period are clearly regulated and that the seller is given information about conditions that are relevant for calculating the earn-out in the period.

A particular topic is whether the earn-out mechanism can have tax consequences for the seller and the company. This is relevant where one or more of the (ultimate) sellers will have roles in the company during the earn-out period, for example as employee or board member. If the earn-out is arranged so that it in reality is remuneration for performance of work or directorship, all or part of the sale consideration for the shares may be reclassified from capital income to employment income. This can result in significantly higher tax for the seller and the company may be obliged to pay employer's tax on the amount that is reclassified. The sales consideration can typically be reclassified as income if the seller undertakes to work for the company or buyer during the earn-out period (or a part thereof) or if the seller's resignation from the position during the earn-out period has consequences for the right to earn-out.

AGP Advokater has extensive experience in negotiating and designing earn-out mechanisms in purchase agreements. Contact us if you need assistance.

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