M&A; let there be no-doubt, about the earn-out!

Pieter Holthuis

June 14, 2016

Earn-outs ! On the one hand a perfect tool to bridge the inevitable ‘valuation gap’ between a seller and a buyer, on the other hand Pandora’s box when it’.

What is an earn-out ?

An earn-out is a mechanism used in M&A transactions whereby part of the purchase price for the company to be sold (“Target”) is deferred and will only be due and payable by buyer to seller upon the performance of the Target’s business (usually in terms of revenue or EBITDA).

Benefits for buyer and seller

Earn-outs can be very useful to help move a deal forward when an optimistic seller and skeptical buyer cannot agree on the value of the Target. Let’s say seller values the Target at 100. Buyer is willing to pay 100, but only if the EBITDA continues to be at least 10 for two consecutive years after closing. To bridge the gap and reduce risk, buyer proposes an earn- out:

  • buyer pays 80 on closing;
  • another 20 will follow post-closing, but only if the EBITDA turns out to be 10 for the next two years.

This earn-out mechanism helps buyer to (i) reduce the risk of overpaying for the Target, (ii) defer payment of part of the purchase price and (iii) pay the earn-out with the realized future profits of the acquired business.

So what’s in it for seller ? Simply put, seller might be able to close a better deal: if the earn-out is subject to performance milestones of the Target, and the deal offers substantial strategic benefits and synergies, the earn-out might result in a higher purchase price. Please note that for tax purposes future earn-out payments – just like the purchase price – fall under seller’s participation exemption (deelnemingsvrijstelling).

Earn-outs are popular

Over the last five years we have seen that earn-out clauses have taken a dominant position in M&A transactions. In 2014, more than 1 in 4 (26%) of the transactions in the US (deals worth $50M – $500M) included earn-out clauses, while in Europe 1 in 5 (19%) of deals, up from 1 in 7 (14%) in 2013, had an earn-out component. In other words, the earn-out is increasingly popular and here to stay.

Risks; buyer’s incentive

Usually, after closing – when the Target is no longer within seller’s control – a buyer may be less motivated to improve the Target’s performance. Alternatively, he might (re)structure the acquired business in such a way that the earn-out milestones will not be met and he won’t have to pay the earn-out.

Last year’s Equinix-case is a good example of a ‘less’ motivated buyer in an earn-out arrangement, which, very fortunate for sellers, took a good turn for them. However, sellers cannot be complacent after this ruling and should create the necessary checks and balances to make sure that an earn-out arrangement works to the satisfaction of both buyer and seller.

What was the case about: Equinix Inc, listed on Nasdaq, is a data center and colocation provider. In 2008 its Dutch subsidiary, Equinix B.V., purchased all the shares in Dutch based data center Virtu Secure Webservices B.V. from four shareholders. Purchase price: EUR 15 million with an additional earn-out of max. 20,000 Equinix shares (i.e. USD 2 million) and EUR 1.5 million in cash, subject to an increase of Virtu’s turnover and profit. After closing, the results of Virtu turned out to be disappointing for Equinix and Equinix was not prepared to pay any earn-out to sellers.

In line with Equinix reasoning, the court also ruled that the milestones of the earn-out were not met and that in principle no earn-out would be payable to sellers. However, despite this conclusion, on the basis of the following facts the court came to a diametrically opposed final conclusion:

  • the Equinix manager who took full control of Virtu after the closing left no room for sellers to contribute to the Virtu’s turnover and results (although this was agreed);
  • contrary to initial construction plans, Equinix caused a 5 month delay in making use of a datacenter in Amsterdam. Furthermore, instead of EUR 7 million, Equinix spent EUR 26 million, negatively effecting Virtu’s result for the short-term;
  • the same manager focused on the datacenters in Amsterdam while ignoring the datacenter in Enschede (prior to closing, Enschede realized an annual growth of 40-50%);
  • in 2009 Equinix transferred the datacenter in Amsterdam from Virtu to Equinix, without making any reference to this divestment in the annual accounts of Virtu; and
  • Equinix did not dispute the fact that after the earn-out period Virtu was in an excellent condition and very profitable.

Based on these facts, the court ordered that Equinix failed in its ‘fiduciary duty’ towards sellers to make an effort to actually achieve these milestones. Hence, Equinix failed in performing its obligations pursuant to the earn-out clause and prevented the performance thereof. So despite the fact that the milestones were not met, the court awarded sellers with the full earn-out payment.

How to mitigate risks for a seller in an earn-out arrangement

To make sure that the outcome of an earn-out arrangement is less dependent on the outcome of the fiduciary duty of a buyer, it is imperative for seller to stipulate clauses in the Share Purchase Agreement (SPA) pursuant to which he is in a position to check, control or influence the earn-out during the earn-out period. In our view, at least the following matters must be included in an earn-out arrangement to make it workable:

  • use crystal clear definitions of milestones, EBITDA and synergies;
  • insert a simple example of how the earn-out will be calculated;
  • have an accountant check the arrangement to see if it makes any sense to him;
  • stipulate that during the earn-out period, buyer will send seller periodically financials, offering Seller the opportunity to check;
  • agree on clauses seeing to the conduct of the business, for instance: “at arm’s length conditions” / consistent business activities / best efforts / refraining from actions specifically aimed at diminishing/increasing the earn out payment / etc;
  • agree on details (who, when, how) regarding the final earn-out payment calculation, ways to object and on how to deal with a dead lock situation.

Conclusion; lessons to be learned

Earn-outs help move deals forward when parties cannot agree on the value of the Target. To minimize litigation the earn-out provisions should be should be well documented, objective and measurable. One should ask himself: what are the milestones and how can they be measured ? What control does seller have in making these milestones ? Is there full transparency and (interim) agreement on the financials on which the earn-out will be based ?

In short: let there be no-doubt, about the earn-out!

Cleber advocaten

Corporate | Restructuring | Dispute Resolution