Earn-out arrangements and takeovers, risk or chance?

What is an earn-out?

With takeovers, we often see that parties agree on an earn-out arrangement. This means that the seller receives one or more additional payments from the purchaser for a number of months or years after the takeover. The amount of that payment depends on the future results of the business sold. The better the results, the higher the earn-out payment.

The earn-out can be agreed for different reasons and in various situations. For example, when the seller continues to work in the business he has sold. The earn-out then serves as an additional motivation to keep the business performing well also after the takeover. This allows the seller to maximize his sale price and for the purchaser it can be convenient for him not to have to pay the entire purchase price all at once. The buyer can also finance that part of the purchase price from results achieved in the future.

Best efforts obligation on the part of the purchaser

However, due to the earn-out arrangement the purchaser and the seller may have conflicting interests in the manner in which the business is run after the takeover. The seller will have an interest in the highest earn-out possible and will therefore aim at short-term results, whereas the purchaser will focus on the prospects and the returns the business can generate in the long or medium term.

To what extent should a purchaser’s business operations take account of the seller’s interest in achieving a maximum earn-out? Does the purchaser fall short if he manages his business operations in such a manner that it is difficult to achieve the maximum earn-out?

Explanation of agreement

The above questions played a role in a recent case that was submitted to the court in preliminary relief proceedings. In the purchase agreement, the earn-out was largely made dependent on concluding new contracts with new customers and for a small part on customer satisfaction. When it became apparent that customers were dissatisfied with the business’s performance, the purchaser decided to focus on increasing customer satisfaction and retaining existing customers and to a lesser extent on concluding new contracts with new customers. According to the seller, this meant that the purchaser violated the agreements made in their purchase agreement and restricted the seller’s ability to achieve the maximum earn-out agreed.

The court in preliminary relief proceedings held that in this case two possibly conflicting interests played a role, namely the seller’s interest in concluding as many new contracts as possible in the short term and the purchaser’s entrepreneurial interest in retaining customers in order to achieve maximum returns in the medium term.

The court went on to state that by agreeing on an earn-out a seller accepts the risk that the maximum payment may not be achieved. In addition, according to standards of reasonableness and fairness the purchaser may or even must take his business interest into account in his contractual obligation to pay the highest possible earn-out.

If, in the present case, the purchaser would not immediately restore the business’s reputation, this would also result in fewer new contracts with new customers. The court ruled that in this case the purchaser acted both in the seller’s interest and in the interest of the business. Shifting the business’s focus was therefore not unlawful towards the seller.

Lessons learned

The above judgment has once again made it clear that earn-out clauses must be detailed and unambiguous in order to avoid disputes. Furthermore, the parties must make clear agreements on the degree of the seller’s influence on the business operations after takeover and the purchaser’s powers to make changes to the business operations before the end of the earn-out period.

Future payments often seem attractive, especially when sellers are convinced of the potential of their business. You should realize, however, that things will change after a takeover and that as a result an earn-out may become a millstone rather than easily earned extra money.

We can of course not exercise any control over your purchaser, but we can advise you in drawing up the earn-out arrangement so that your interests as a seller are safeguarded as much as possible.