The earn-out agreement in M&A deals

The earn-out agreement in M&A deals

Is it a curse or a blessing – and for whom?

The earn-out is increasingly used aspart of the closing deal in M&A transactions in the logistics industry – a blessing for sellers? After all, they retain an option right to future success factors. But is an earn-out really the better alternative to classic one-off sales of companies? What risks and problems arise from the obvious advantages – and how can they be successfully avoided?

A Comparison in advance: Earn-out versus one-off payment
Conceptually possibly confusing, but with a one-off payment it does not matter whether the purchase price is actually paid in a single payment or in several instalments. The decisive point is that a seller sells his company without an option right to future profits at a single – i.e. one-off – sales price. The situation is different with an earn-out: Here, in addition to a basic purchase price, an additional purchase price is agreed for the company – which results from a share in future profits. Fixed parameters, event-related or cumulative parameters as well as variable values can be considered.

Possible reference parameters for the earn-out additional purchase price
The additional purchase price determined as earn-out can refer to various business variables from the profit and loss account or real variables from the sales volume. Direct profits from a specific technology, performance or product category are also possible.

Fixed parameters as a basis for the earn-out
In addition to the gross profit in a given period, EBIT, cash flow or headcount are also relevant here – as well as other fixed parameters with a clear characteristic value.

Earn-Out based on cumulative figures
For this earn-out basis, parameters are agreed upon over several periods to be determined, over which they are cumulated: For example, this could be the gross profit over three years.

Earn-out based on variable values
Here the earn-out is determined depending on a changing basis. For example, the percentage development of EBIT compared to the previous year.

Event-related variables as earn-out reference
With this variant, an additional purchase price is due when a certain event to be defined when the contract is concluded occurs: this can be, for example, an increase in the number of customers or the retention of groups that bring profit or prestige – perhaps an agent network.

The advantages of an M&A deal with earn-out are obvious – or not
At first glance, it seems clear why earn-out in M&A deals in the logistics industry is an increasingly common component of price agreements. However, the supposed advantages are always accompanied by risks and potential conflicts.

The earn-out can save tough negotiations about the company value
Time, effort and external costs for an elaborate company valuation that is fair to both sides can actually be saved in the first instance with an earn-out.

But: Often this is only a postponing effect – the pain on both sides simply occurs later: namely when the additional purchase price actually due has to be calculated. Then the seller must also “blindly” rely on the correctness of the figures presented by the buyer. Unless he has negotiated in advance in the best possible way about traceability – which is hardly less tenacious than an agreement on the company value at the time of the conclusion of the contract. After all, it is not exactly desirable for buyers to have to disclose results to the previous owner of the company. Further difficulties: to determine the size that makes sense for both sides, to determine the periods to be considered and to guarantee measurability.

An earn-out can enable risk sharing in the event of differing views on the economic development
Especially in the case of start-ups or innovations that have not yet been established, the economic development cannot yet be definitively analysed at the time of sale. In such cases, a later periodic evaluation of the actual results can actually be useful for both sides.

But: Either the seller no longer has any influence on the future earning power after the sale of his company – in this case, a dispute about the responsibility for results not achieved as expected is inevitable. Or the seller remains in a significant position after the sale, at least for the earn-out period – this, however, considerably limits the buyer’s room for manoeuvre: a frequent knock-out criterion for the sale of a company in general.

The seller can achieve a better selling price through the earn-out – the buyer defers payment
Event-related variables in particular offer the seller the attractive prospect of future profits – especially if these could not yet be clearly analysed at the time of the sale. At the same time, the buyer has to spend less money on the basic purchase price – and can draw on profits made later to pay the additional purchase price.

But: The risk for the seller lies here especially in a period that is too short for the determination of the profit – possibly the buyer can then delay the profit without incurring a loss of his own. For him, however, there is also a risk: If other parameters do not develop as desired, the total profit will not be correspondingly high – then the deferral threatens delayed indebtedness.

Conclusion on the earn-out: More complex than at first sight – blessing only with professional elaboration
It has been shown that earn-out negotiations are only superficially effective in the case of discrepancies in purchase price and valuation – because they often merely shift expenditure and conflict potential to the rear. If the earn-out regulation is to be serious and not lead to disputes later on, intensive negotiations are also required in the run-up to the negotiations and the elaboration of the traceability during the term of the agreement. Company sellers should not be blinded by the supposedly lower risk and should also fall back on the individual and foresighted support of an M&A expert in the case of an earn-out.

Nevertheless, three general recommendations can be derived:
The earn-out regulation is best suited for sellers who will remain in the company for a certain period of time and who are thus allowed to influence economic developments.

Event-related earn-outs in particular seem to lead to better results.

In addition to determining the right size, it is essential to contractually guarantee the correct analysis period and traceability.

Thus, the earn-out can be a real blessing instead of a belated curse – at least for the seller.