Earn outs can be encountered in the context of sales and purchases of company shares. They are a payment mechanism enabling the buyer to pay an element of the purchase price to the seller after the sale…but only on the condition that the business attains pre-agreed targets after the transfer.

In the right circumstances, there will be good reasons for having an earn out mechanism. For example, if a selling shareholder is key to the continued profitability of the business, an earn out could require that seller to continue working in the business for a period of time to “earn” the sale price that he has agreed with the buyer. Provided he is willing to continue working in the business under new management (not always a “given”), the benefit to the seller is that he can obtain a higher price for the business than he otherwise might. Barring any misfortunes, the buyer has the benefit of securing a significant element of the goodwill of the business over the earn out period and a smooth and personal handover of the business relationships.

In answering the question in the title, earn outs do not always meet the expectations of the buyer or seller. There is a risk on both sides. The buyer and seller can agree on terms over which they have control. However, there will always be things outside the control of the parties that could impact adversely.

There will be a number of assumptions and expectations that both parties will have when approaching earn out negotiations. It will be important for those parties, before entering into negotiations, to analyse and record their expectations and assumptions. That way, they will be better informed to deal with some of the complexities of earn out negotiations. Common issues that they will need to address include:

  1. the performance indicators against which the earn out will be measured. This usually needs detailed and focussed consideration and a very good understanding of how the company’s accounts are compiled and presented;
  2. the length of the earn out period;
  3. the timing of the earn out payments to the seller (bearing in mind the possibility of contingent payments to the company);
  4. the process for resolving any appeals and disputes;
  5. the seller’s continuing control in relation to the management of the company during the earn out period. Some sellers struggle with this aspect: a culture change becoming a culture shock; and
  6. whether there will be any restrictions on the company’s activities during the earn out period which could have a negative impact on the earn out itself.

Being part of the purchase price, the earn out payment provisions will need to be very carefully considered. The tax implications on both the company and on the seller will also need to be borne in mind.

An earn out mechanism can lead to a significant payment. Get professional advice to narrow the risks on the outturn of the earn out.