Various (also not directly financial) reasons to enter into an earn-out arrangement
When selling a company, a difference of opinion about the results to be realized by the company in the future (and thus the value of the company) can be bridged by an earn-out arrangement, whereby part of the purchase price is only due if pre-agreed financial results are (timely) realized after the acquisition. But also other (not -directly- financial) uncertain circumstances that may influence the value of the company, may be reason to agree that part of the purchase price only has to be paid if an event occurs after the acquisition of the company. Consider, for example, the retention of key employees for a minimum period after the acquisition, the acquisition of an important license, or the winning of a strategically important order.
Advantages of an earn-out arrangement
The advantage of an earn-out arrangement for the buyer is the certainty that part of the purchase price only has to be paid after the agreed earn-out results have actually been realized. Conversely, an earn-out arrangement offers the seller certainty that if an earn-out result is realized, a higher purchase price will be received. So far only positive.
Problems in implementing an earn-out arrangement
But practice, as always, is recalcitrant. For example, there may be a difference of opinion between the seller and buyer as to whether or not an earn-out result has been realized (on time). It may also be, that the seller is of the opinion that the buyer did not make sufficient efforts after the acquisition to realize an earn-out result (or even frustrated the realization of an earn-out result). What is the seller’s position in such situations?
Risk for the seller in an earn-out arrangement
First of all, by entering into an earn-out arrangement, the seller accepts the risk, that part of the purchase price will turn out not to be due. Having said that, the seller can ensure that the risk of an earn-out dispute with the buyer is considerably reduced. It is very important that the earn-out arrangement(s) is/are properly worked out in the purchase agreement.
Uncertainty for the seller
Without specific agreements on this in the purchase agreement, the buyer may and must run the company in a way that puts the interest of the company first, but he must also take into account the interest of the seller in maximizing an earn-out arrangement in the considerations and policy decisions he makes. A role in this is that (market) circumstances may change and that the seller must take into account that this may lead to new insights. Expectations and predictions that existed when the purchase agreement was entered into can therefore be overtaken by new developments, as a result of which the buyer must adjust policy and respond to these in the interest of the company.
Also in such a situation, the buyer may be expected to reasonably accommodate the seller’s interests in the (maximization of the) earn-out. Despite this (general) obligation of the buyer, the situation of the seller remains uncertain and this can easily lead to disputes with the seller and ultimately to the (full or partial) loss of the earn-out.
Importance of a well-developed earn-out arrangement
The seller can avoid such a situation by including a well-developed earn-out arrangement in the purchase agreement, which clearly sets out the (concrete) efforts and actions required from the buyer to maximize the earn-out. Furthermore, in the earn-out arrangement it can be agreed which (policy) developments are and which are not taken into account when determining the earn-out result.
