“Never spend your money before you have earned it”.

These wise words from Thomas Jefferson would certainly apply to Sellers who have agreed to an earn-out or to Buyers looking to protect their business purchase.

Earn-outs may well be used more frequently due to this year’s events:

  • An earn-out operates so that the parties in a business purchase can reference the current year and future earnings of the business, rather than the historic valuation. The earn-out can often apply for 2 or 3 years.
  • Given that this year’s profits are likely to have fallen, an earn-out may be a good strategy to ensure that a sale can still go through, rather than being paused (for now).
  • Buyers can protect themselves from overpaying, and Sellers still have the certainty of their exit now, but with an anticipated upturn in the future.

The key is negotiating targets at a level which are realistic but sufficiently aspirational to Sellers who are staying on. Where Sellers remain with the business post-sale, they have the opportunity to maximise the sale price, often coupled with remuneration based on their continued employment or consultancy.

For Sellers, there are obvious risks:

  • No one could have anticipated this year’s events. Missing a target can mean they do not receive the earn-out at all and are left with only the sale price at completion. This could have been offset with a sliding scale approach.
  • Sellers may feel that they are not in control of their destiny in a larger organisation. They will need protections to allow them to maximise the earn-out and a clear strategy to achieve this – all agreed with the Buyer before completion.
  • Any solution based on the future position will have greater scope for dispute, rather than the full sale price on completion or deferred sale price (not based on an earn-out).

Where the parties have completed already with an earn-out agreed, then they could consider the following, which should always be recorded in writing as a variation of a the sale and purchase agreement:

  • If the target has been missed due to the economic downturn, the Seller could try to negotiate for the target(s) to be revised. The Buyer is not obliged to accept this, but may consider it to protect the goodwill of the business and keep the Seller motivated to still maximise the earn-out for the future security of the business facing today’s challenging trading.
  • If the target has been met with the earn-out still payable, but the Buyer is unable to pay it, then rather than relying on the contractual position (for payment due), interest could be paid, instalments or security put into place over the Buyer’s assets (if not already agreed at completion).

One of my clients completed a sale last year with an earn-out with certain protections in place. For example, there is the opportunity to “make up lost ground” if one year’s target is missed, then this may assist where the earn-out is spread over several years. A place on the board and shareholding (and shareholders’ agreement) in the Buyer can assist, but not usually on its own. Also, security over the assets of the Buyer or the shares actually sold may help in the event of enforcement if the earn-out is due but not paid.

As we come to the end of a tumultuous year, let’s hand back to Thomas Jefferson. He also said “I like the dreams of the future better than the history of the past.” So, whilst taking a break this Christmas and New Year, it’s a good time to take stock and plan for the future of your business.

The contents of this article are intended as guidance for readers. It can be no substitute for specific advice. Consequently we cannot accept responsibility for this information, errors or matters affected by subsequent changes in the law, or the content of any website referred to in this article. © Mundays LLP

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