By Barry Carus, Esq.

 A seller in the private M&A deal-making process frequently faces a threshold deal issue during the early stages of discussions with potential buyers – what is the timing of payment of the purchase price consideration? Potential buyers may wish, for various reasons, to reduce the closing date cash payment by shifting a portion of the purchase price into conditional earn-out payments. As a seller considers potential buyers with its financial advisor, it is critical that they compare all offers on a side-by-side basis to determine the overall economic value of each offer both on an aggregate basis and on a component basis. Accordingly, a seller should perform an appropriate risk analysis, including (i) the ability to earn the earn-out payments due to the likely loss of control of seller’s principals over the business once it is sold; (ii) the conditions for earning the earn-out payments; and (iii) the financial wherewithal of each potential buyer to make the payments.

Seller should understand the earn-out payment risks even before the LOI stage, as buyers invest significant time and money into the due diligence process and will generally require “no-shop” provisions in the LOI. Thus, once the LOI is signed, a seller may lose negotiating leverage with the buyer to make changes to the earn-out formula, and the ability to leverage one potential buyer against another will likely be negated, at least until the no-shop period expires. Further, during such no-shop period, other buyers will have probably moved onto other projects and seller will risk losing the initial buyer market interest surrounding the business being sold, and seller may be faced with the daunting task of launching the process over again if it turns out that the earn-out payment component of the deal is unfavorable to seller. It is, therefore, critical for seller to work with its professional advisors prior to signing the LOI to understand the risks that accepting conditional earn-out payments may pose to achieving maximum deal value.

Buyers often try to mitigate their deal risk by tying a portion of the purchase price to the post-closing performance of the acquired business. Conditions for earning earn-out payments may be based upon post-closing customer and revenue retention, achieving gross margin and/or profitability targets, or perhaps a combination of such factors. By pushing out the earn-out payments over a period of years, buyers reduce their up-front closing cash requirements and their cost of capital, thereby improving their ability to accelerate return on investment on the up-front investment. This may allow buyers to use the projected positive operating results to fund all or part of the earn-out payments. A seller needs to understand the post-closing landscape, including (even if one or more of seller’s principals remains active in the business post-closing) that it is likely that a prompt transition of decision making authority and control to buyer will occur, and seller’s ability to earn the earn-out payments may hinge on factors out of its control. On the other hand, a buyer generally seeks to “hit the ground running” with the business it just spent a considerable sum to buy, and the hope is that buyer and seller share a common focus for the business to meet its post-closing projections so that buyer can achieve an immediate return on investment, in which case buyer should be more than happy for seller to earn its earn-out payments. If seller is unsure that its buyer shares this common focus, seller should quickly shift to another buyer.

The essential terms of any earn-out payments should be negotiated early on, and be included in the LOI, including: earn-out payment amounts; conditions to earning the earn-out, timing of payments of the earn-out; ability to earn catch-up earn-out payments if all or any portion are missed for a prior period; parent guaranty of buyer’s earn-out payment obligations if buyer is consummating the deal through an acquisition subsidiary; and the possibility that buyer will require the earn-out payments to essentially serve as a setoff fund for indemnity claims to be negotiated in the purchase agreement. Sellers sometimes sign LOIs without appropriate legal review and negotiation as aggressive buyers push hard to get the LOI signed up as quickly as possible, so they can get into the lock-up period, commence due diligence, and preparation of a purchase agreement. If the essential earn-out terms are not substantially negotiated in the LOI, seller and its counsel will face an uphill battle to get the buyer to make changes. Seller may have some leverage in terms of the LOI not being binding and subject to execution of a definitive purchase agreement, but as the deal process gains momentum, the seller may become more invested in selling, and its investors and/or bank, as is often the case, may be pushing for an exit. Therefore, the seller may be faced with the impractical task of halting the process with the buyer and moving to another buyer, so it is critical to get the earn-out terms ironed out prior to signing the LOI.

Before going out to test the market, a seller should get a sense of its enterprise value from its financial advisor, which will serve as baseline for determining potential deal value. Seller and its financial advisor should then work through a preliminary funds flow analysis assuming different closing cash payment and earn-out payment levels, so that seller is educated on the level of deal proceeds it will take to meet its obligations to its investors, banks, creditors, employees, and the proceeds that may be available for its principals and/or management team. Depending upon the nature of the business and the industry, seller’s financial advisor may have insight if a buyer market exists to pay the full purchase price at closing or if it is more likely that the buyer market will require seller to accept a partial earn-out, with a percentage of the overall purchase price subject to an earn-out. Seller can then begin to consider if the amount it may receive at closing will make it economically feasible to consummate a deal and hand-off ownership and control to the buyer. In performing this analysis, seller should work with its financial advisor to develop best case and worst case financial assumptions regarding the earn-out payments and how those scenarios impact the ability to reach the deal objectives. Seller also needs to perform due diligence on buyer and review buyer’s basic financial information to analyze if there are any obvious limitations on buyer’s ability to meet any future earn-out obligations. Buyers often resist or delay providing this financial information, but seller should insist on it before an LOI is signed and seller becomes further engaged with buyer.

Proper planning should give a seller and its principals a baseline foundation to test the buyer market with a sense of awareness concerning potential deal value and deal structure. Of course, the market itself – whether there are single or multiple potential buyers – will dictate the direction the process takes in terms of deal value, and deal structure, including whether earn-out payments will be a component of the deal. In a perfect world, a seller will receive the full purchase price at closing, but that may be an unachievable goal, so before proceeding with the LOI, seller should engage experienced professionals to assist in the negotiations with potential buyers.

Experienced professionals can guide seller in attempting to structure the earn-out based upon a limited set of simple performance metrics. A seller should resist a buyer’s attempt to construct an earn-out structure based upon a complicated set of performance metrics over multiple years such as profits, earnings, customer retention and other variables, as achieving the target levels may be out of seller’s control thereby jeopardizing the likelihood that seller will achieve the earn-out. Instead, seller should seek a straight-forward earn-out structure based upon easily quantifiable metrics such as retained revenue from existing customers and possibly revenue growth over a limited period. Simplifying the earn-out structure by using basic milestones should in turn simplify the earn-out provisions in the purchase agreement and help ensure that the goals and objectives of seller and buyer are aligned.

Consummating a sale of a privately-held business is a complex process, particularly when there is a disparity in a seller’s sale price and multiple expectations, and a buyer’s purchase price and multiple targets. An earn-out is the likely answer to narrow the gap between seller and buyer so that they can proceed with the deal. A seller should line up an experienced professional team so that it is prepared to negotiate any earn-out issues and questions early in the deal process.