Tuesday, June 23, 2009
Suppose a buyer is negotiating the terms of a potential acquisition of a family business when the parties encounter an issue over valuation. The seller’s projections show 500% growth over the three years following the sale. However, the buyer doubts these projections and therefore thinks the business is worth only a fraction of the seller’s asking price. This is a classic circumstance in the M&A world.
Often, the parties will bridge this valuation gap through the use of an earnout. Under such an arrangement, the seller gets paid a percentage of the asking price up front, and the parties agree to additional future payments if the company meets specific financial goals. For example, the buyer might agree to pay 75% of the purchase price up front, with another payout contingent on generating a particular amount of cash flow over a three-year period. This contingent payment could be binary, meaning it is paid or not depending on whether the target is hit, or it could be based on a sliding scale. For example, 50% of the contingent payment is made if 50% of the target is hit, 60% is paid if 60% of the target is hit, and so on.
Earn-outs are complex and must be carefully structured. For example, since the ultimate price payable pursuant to an earn-out provision will depend on future performance, the seller generally attempts to retain control of the business during the earn-out period to assure that changes in operations after the sale do not affect the ability to attain the specified target. The buyer, of course, often resists any restriction on its ability to run the business as it sees fit after the closing.
Here’s a recent article from BNA’s Mergers And Acquisitions Law Report highlighting many of the pitfalls to be avoided.