Thinking | 19 August 2020
On pandemics and… earn-outs
By Chris Brown and Paul Simos
The pandemic has wreaked havoc on earn-outs. We have spoken to a number of sellers whose recent deals have soured as a result of the pandemic slowdown. How earn-outs and similar arrangements hold up of course depends on the sector and on individual businesses, but very few businesses have come through the last six months unscathed. Fewer still have delivered on ambitious growth targets to achieve their full value potential.
The nature of earn-outs
An earn-out is a mechanism designed to bridge the value gap between sellers’ unfettered optimism about the future growth prospects of their businesses, and sceptical buyers who are reluctant to pay for businesses which may struggle to maintain earnings at historical levels (let alone grow them). The earn-out gives the seller a motivating stake in the target business’ growth, usually measured over a one to four year period by reference to pre-agreed earnings stretch targets.
For the seller, the lower the amount of proceeds at risk (and the shorter the period the earn-out operates), the better. This, of course, assumes that the sold business is fairly valued and the bulk of the consideration is paid at completion. A one year or shorter earn-out should only involve a relatively small proportion of consideration at risk in case unforeseen events - whether the loss of a key customer or the onset of a mysterious new virus - deliver a disproportionate, one-off blow to earnings. If a larger proportion is at risk, the target’s financial performance is usually measured over a longer period, and cumulatively.
For the buyer, a properly structured earn-out is one where any additional purchase price is comfortably funded from meaningful growth. If the business shoots the lights out, and the seller receives a handsome additional payment as a result, then there are smiles all around. Conversely, if targeted earnings do not materialise, then risk crystallises and falls squarely on the seller’s shoulders. This is why such arrangements refer to putting money ‘at risk’.
External risk factors are often addressed in commercial contracts through force majeure provisions, (or, in a transactional context, through material adverse change (or MAC) clauses). MAC clauses protect the buyer against damaging events and shocks occurring between signing and completion, where such occurrences are reasonably expected to cause material detriment to the target business.
However, the pendulum does not swing the other way after the business has been sold. Earn-outs do not typically include MAC-like provisions, giving the seller another roll of the dice if an unexpected shock occurs and the business is adversely impacted. The existence of earnings and earnings growth is the key. If the earnings do not show up (for whatever reason), then the earn-out is not unlocked or is only partially successful.
Clearly, there is scope for inequity in this. Even if both parties go into the arrangement knowing that success depends on the required level of earnings being achieved, a temporary, unforeseen drop in earnings is nevertheless likely to penalise the seller and deliver at least a minor windfall to the buyer (assuming the business emerges under full sail out of the other side of the crisis and is not wrecked in the meantime). The inequity doubles if the deferred consideration includes a hold-back component - a so-called ‘rise and fall’ provision - under which the buyer can withhold and retain, and sometimes clawback, base purchase price if earnings fall below the benchmark.
Can anything be done for the seller?
The short answer is that it depends on how the earn-out clause is written and how a Court would interpret it. Outside the agreement, there is likely to be justification and good commercial sense in taking another look at the final position.
Our experience, from drafting, reviewing and negotiating these provisions, is that short of interference or neglect by the buyer, the seller may struggle to find a legal ‘get out of jail card’ based solely on the terms of the contract.
With earn-outs, there is a tension between the buyer giving the seller enough rope to continue running the business and achieving targeted short term growth, versus the buyer enjoying the fruits of ownership (including integrating the business into existing operations and otherwise running the shop for longer term success). This usually results in a fairly restrained and balanced set of protections which broadly fall into three categories:
- Restriction on the way in which the new owner operates the business, including not shutting the seller out of management (or terminating their employment without just cause), not changing the business or service delivery model materially, not changing pricing, not using the acquired business as a loss-leader (for other products or services the buyer sells), not passing excessive costs through the acquired unit, not diverting opportunities away from the business to another unit the buyer owns, and ensuring that the business has adequate working capital for the duration of the earn-out.
- Normalisation of earnings comprised in the earn-out calculation. For instance, excessive head-office management fees and governance costs, audit fees (e.g. when the business has not been audited previously or the audit cost was modest in comparison), and non-arms-length elements of intra-group dealings are likely to be excluded from the calculation.
- Acceleration of the earn-out amount (whether in full or proportionally based on run-rate) in the event of a sale of the business or its assets, discontinuation of the business other than as a result of financial failure, or certain other clearly defined, prescribed events which would have the effect of frustrating, curtailing or diminishing the earn-out.
In light of the current COVID calamity, sellers should look closely to the agreement to see if any of these undertakings and other protections have been infringed or otherwise enlivened. In most cases, they will not have been simply because the reason for checking is an external crisis or other event outside the buyer’s control or influence.
However, the way in which a buyer responds to a crisis may involve a level of interference that is at odds with the seller’s earn-out protections. For instance, we are aware of a seller who sold their business 18 months ago. This business has turned out to be reasonably COVID-proof, whereas the buyer’s other activities have not fared so well. In response to the business slowdown, the buyer required all staff (including those in the acquired unit) to move to 80% ordinary time and pay. But for a timely discussion between the seller and the buyer, this would have resulted in the acquired unit failing to book an important level of business in time to hit its final earn-out target. As it was unclear whether the buyer would infringe its commitment to maintain the existing level of resourcing in the acquired business by furloughing staff to the same extent as all other staff, the parties wisely chose to negotiate an extension and variation to the earn-out.
Sometimes, businesses which are susceptible to volatility in a particular market or commodity price, or whose earnings are closely correlated with that market or price, will include an index or price movement mechanism in their deferred consideration arrangements. If the index or price moves between closing and the relevant earn-out determination date, then the impact of those movements (whether positive or negative) is applied to the target earnings to set a normalised (and fairer) milestone. This is one way in which parties can address risk resulting from external factors (albeit in very specific circumstances).
Good commercial sense usually prevails
Perhaps the strongest argument for addressing inequity is not based on fairness, but on the fact that the buyer’s need to steady, integrate and grow its acquisition has not diminished and is perhaps greater now than before. Practical reliance on the seller and the existing management team creates strong alignment which often provides the impetus for agreeing new terms.
Future norms are shaped by past traumas (even where one hopes those traumas have little prospect of being repeated in the next hundred years or so). As hindsight is always 20/20, we can expect transaction agreements in the future to address unknown risks and threats by requiring the parties to renegotiate if the unthinkable or unforeseen arises. However, returning to the theme above, in the absence of demonstrated earnings growth, there is no single circuit-breaker in this situation other than the parties’ willingness to do a deal that benefits, or at least minimises damage to, both sides.
 Thank you, Billy Wilder.
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