In merger and acquisition (M&A) transactions, the earn-out mechanism serves as a strategic tool for conditional payment based on the prospective performance of the acquired entity. This mechanism is particularly prevalent in transactions in which substantial valuation discrepancies exist between the parties, or when there is anticipation of significant post-acquisition growth in the business activities of the acquired entity.
An earn-out arrangement involves the seller agreeing to receive only a portion of the consideration at the transaction’s completion, with the remainder contingent upon the acquired company’s achievement of specified financial or operational milestones during a defined post-completion period.
The Seller’s Standpoint
From the seller’s standpoint, the greater the anticipated future profits of the acquired entity, the higher the consideration sought in the transaction. Conversely, the purchaser may be reluctant to agree to a high valuation based on optimistic profit forecasts that may not materialize. In scenarios in which the purchase price is predetermined without an adjustment mechanism, the purchaser exclusively assumes the risk associated with non-realization of the acquired company’s anticipated profitability.
Use of the earn-out mechanism, however, facilitates the alignment of expectations and equitably distributes the associated risks and opportunities between the parties. It is advantageous for both parties, as it enables the seller to secure a higher consideration contingent on the sustained growth of the acquired business post-transaction, while concurrently providing the purchaser with a degree of protection should the company fail to achieve the projected financial targets.
Earn-Out Complications
Despite its appeal, the earn-out mechanism is not devoid of complications. For instance, the seller and purchaser may have conflicting objectives regarding the company’s management during the earn-out period. While the seller may prioritize short-term profitability targets, the purchaser may focus on long-term growth strategies. Furthermore, external factors beyond the seller’s control, such as economic fluctuations or regulatory changes, may influence the company’s performance during the earn-out period, which could affect the final consideration. Additionally, the seller is unable to influence the purchaser’s post-acquisition decisions and might be disadvantaged if the purchaser makes business decisions that are not aligned with the earn-out objectives.
The necessity of defining an earn-out mechanism in an M&A agreement inherently increases the transaction’s complexity, as the parties must agree on the specific targets and parameters that will trigger the future consideration payments to the seller.
The most significant challenge lies in accurately defining the performance metrics that will underpin the earn-out mechanism. These metrics can include revenue, profit, gross profit, EBITDA, and other financial indicators. It is imperative to explicitly and accurately delineate these metrics in the agreement and to ensure it is possible to objectively measure them, taking into account potential significant changes in the market or business environment that could impact the company’s performance independently of either party’s actions.
Lastly, it is essential to structure the earn-out mechanism in a manner that precludes the possibility of manipulative behavior, thereby eliminating any incentive for the purchaser to intentionally weaken the company’s performance during the earn-out period in order to reduce the consideration payable to the seller.
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Adv. Ilan Blumenfeld (Partner) and Dor Levy Tam from the Local Commercial Department will be happy to answer questions regarding Earn-Out mechanisms, and other M&A related questions.