By Claire Brown and Kurt Ruttum
Often, the parties in a business sale will designate a portion of the purchase price to be paid out over time or otherwise made contingent on the performance of the business after the transaction is complete. This “earn-out” can be a meaningful portion of the total consideration paid to the seller, and can help the buyer allocate risk and manage cash. An earn-out can be one of the most heavily negotiated parts of any deal, as it materially affects the value of the transaction for both parties. There are few things in the business community that have not been upended by the recent COVID-19 pandemic, but anyone with a current earn-out in process should take a hard look at available options.
What Does the Agreement Say?
Earn-out terms can vary widely across transactions, meaning that developments due to COVID-19 can affect them in different ways than they affect the underlying business. For example:
- Measurement Period: An earn-out may be based on company performance before December 31, 2019, but payable during 2020, meaning that the dollar value of the earn-out would not be affected by COVID-19 even though the buyer’s ability to pay it could be. On the other hand, an earn-out measurement period that includes any part of 2020 might be drastically affected, even if the underlying business remains fundamentally healthy.
- Performance: Earn-out calculations often rely on certain metrics tied to the health of the business. For example, an earn-out payment may be higher if the business is able to renew or extend a valuable contract with a key customer. Other earn-outs depend on financial measurements such as revenue, margin, EBITDA, or profitability. While a business adjusting to COVID-19 might currently have decreased sales, margin could remain the same. As businesses furlough or lay off employees and reduce costs, EBITDA or profit might be affected differently than revenue. Depending on the metrics used, the earn-out might be significantly affected in a way that does not accurately reflect the actual effects of COVID-19 on the business.
- Milestones: Some earn-outs are tied to specific milestones, such as the development of a new product or successful entry into a new line of business. These milestones may no longer be achievable.
- Business Models: Future performance anticipated at the time of a transaction and used to develop earn-out terms is usually reliant on modeling. Obviously, any model that did not take COVID-19 into consideration may no longer reflect reality.
The transaction agreement may also contain a “force majeure” or “material adverse change” clause specifying additional rights or obligations of the parties if a serious and harmful event takes place. These contract provisions should be considered when analyzing a possible re-negotiation of an earn-out. For a discussion of force majeure contract provisions in light of COVID-19, please see here.
Earn-Out Protections
In many cases, a seller maintains some control over the business during the earn-out period, either through direct involvement – such as remaining an officer or Board member of the company – or contractually by obligating the business to be operated in a certain way. For example, a buyer may agree in the transaction agreement to keep salaries at a certain level, invest a minimum amount in research and development efforts, maintain certain levels of inventory, refrain from pledging assets or taking on debt, or otherwise take actions that could adversely affect an earn-out. These undertakings may no longer be desirable, or even possible. Furthermore, a buyer may have had certain expectations regarding its ability to attract growth capital that are no longer realistic.
Time to Renegotiate?
Buyers, sellers, or both may benefit from a re-negotiation of earn-out terms. The parties, one or both of whom may have fiduciary obligations to shareholders in addition to economic or personal goals, may wish to explore modifying any of the terms described above.
A key consideration for each party is whether it believes the fundamentals of the business have been affected by COVID-19, or whether the business will be as viable in the future as it has been in the past. In addition, the parties should consider the goal for any re-negotiation – is it to update the terms to fairly reflect the original intent of the parties, to preserve the value or operations of the business, to retain or even enhance the potential financial gains of one party or the other, to apportion risk to the party with the greater appetite for it, or something else?
Negotiating the allocation of costs, losses, and risks is more challenging than negotiating the division of gains and benefits, meaning that even a friendly relationship after a positive transaction will not necessarily lead to a constructive earn-out re-negotiation. Parties with a fraught history due to a difficult transaction are unlikely to have an easy time revisiting those terms now. Yet there is almost certainly some overlap between the goals of any buyer and any seller. For example, a business that performed well during 2019 and is obligated to pay an earn-out in 2020 based in part on 2019 performance may wish to extend the payment period in order to preserve cash, and a seller receiving the earn-out may agree to extend the payment in exchange for increasing the weight of 2019 performance relative to 2020. As another example, a buyer that was planning to use cash to make an earn-out payment during 2020 may instead want to provide part of the payment in stock. The seller may be persuaded to accept stock instead of cash because doing so allows the seller to continue to share in the gains of the business going forward. A seller may also request additional oversight, such as an audit right, that was not granted in the original earn-out but may be valuable to the seller.
A party negotiating changes to an earn-out will likely benefit from considering the other party’s perspective. It may also be useful to engage a trained mediator to help navigate the issues in a constructive way to reach a mutually beneficial solution. It will be useful for the parties to focus on the reality of the post-COVID-19 world rather than looking back to pre-transaction projections or assumptions. For a broader overview of negotiating strategies during the COVID-19 pandemic, please see here.
Tax Considerations
The tax effects of earn-out consideration on the personal finances of the seller were likely a key consideration when negotiating the terms of the original transaction. Any re-negotiation should involve appropriate tax professionals to avoid unintended negative tax consequences.
Current M&A
We expect to see a bigger portion of the purchase price in M&A transactions during COVID-19 to be paid over time and tied to post-closing performance. In other words, there could be more frequent reliance on earn-outs. Buyers will be eager to share the risk that business will not return to normal anytime soon, but may also be willing to share the rewards if things normalize more quickly. Sellers looking to receive cash up front with little to no earn-out can likely expect a lower purchase price or use of other risk-sharing mechanisms such as requiring seller financing through a note or a larger escrow. General economic uncertainty may also lead sellers to request or require a parent guaranty or additional form of security that they may not have thought necessary before COVID-19.
Conclusion
If you are a buyer or seller currently in an earn-out period, you and your counterparty may want to consider whether any terms should be re-negotiated. Our experienced transactional and tax attorneys can help you evaluate these issues and, if appropriate, help negotiate and implement any changes.
This client update is prepared for the general information of our clients and friends. It should not be regarded as legal advice. If you have any questions regarding this update, or for more information about this topic, please contact the attorney with whom you normally consult or an attorney in our M&A Practice Group.
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