"A company, X, with a long-standing reputation and modest current earnings but a promising future, is on the block for sale. A buyer, Y, is seriously considering buying X, but is of the opinion that the ' 500 million price tag for X is unjustified, given its present position and the fact that its assets are worth ' 350 million only. From the owner’s/promoter’s...
"A company, X, with a long-standing reputation and modest current earnings but a promising future, is on the block for sale. A buyer, Y, is seriously considering buying X, but is of the opinion that the ' 500 million price tag for X is unjustified, given its present position and the fact that its assets are worth ' 350 million only. From the owner’s/promoter’s perspective the justification for the apparently hefty price tag is a projection of a significant increase in the earnings of X over the next few years."
Such a variance in selling price and expectation between buyers and sellers is commonplace. When sellers and buyers come to an impasse on valuation based upon assumptions about valuation and/or future performance, the final purchase price gap in negotiations for the sale of a business is sometimes bridged through an ‘earn-out’. More so, in situations where the disparity results from differing perception of future performance of the seller and the buyer or the outlook for a new product or initiative, an earn-out offers an appealing alternative to the typical “split the difference” compromise by tying the payment of the “contentious” portion of the purchase price to the actual outcome in the future.
What is an “earn-out”?
An earn-out is a type of contingent payment. It is paid by a business buyer to the seller upon the attainment of certain predefined post-closing events (future earnings, performance targets or some other benchmarks). The earn-out amount is based on agreed performance criteria and is generally calculated as a multiplier with reference to historical profits and/or projections at the time of closing although it may be based on turnover or other financial criteria. As the economic downturn continues (negatively impacting access to funds), which in turn creates uncertainty about future performance, earn-outs will continue to be a tool for bridging valuation gaps.
Earn-out-Negotiation points
Earn-outs can be both legally and financially complex since an earn-out is often resorted to as a result of failure to agree to a business valuation that is deemed fair by both the buyer and the seller. Therefore, a carefully constructed and diligently drafted earn-out provision can create value for both the buyer and seller while mitigating the risks.
Hence, the parties should keep the following principal considerations while negotiating and drafting earn-outs:
- definition and scope of the business activities that are associated with the earn-out need to be clearly highlighted;
- determination of the payout structure and selection of the performance metric-the metric used to determine the size of the earn-out can vary from being a financial metric (e.g., revenue, gross profit, EBITDA, etc.) to an operating metric (e.g., page-views, customers, etc.). Earn-out provisions should include carefully drafted statements about the selection of appropriate accounting measurement standards or methods of accounting for revenues, profits, losses and/or expenses, or other milestone determinants;
- establishment of the earn-out period-the parties should carefully consider how much time they will need to assess the seller’s performance while ensuring that they don't motivate the seller’s management to maximise short term revenue at the expense of growth and sound long-term business planning-usually the parties keep the earn-out period between 3 to 5 years;
- earn-out provisions should include carefully drafted statements about who controls the successor entity-the method of operating the business after the closing; and,
- dispute resolution procedures should be established in advance to resolve future disagreements concerning the earn-out calculation in a fair and expeditious manner.
Additionally, specialist tax advice should be sought when entering into an earn-out arrangement. The earn-out consideration may be subject to either capital gains tax (CGT) or income tax depending upon the structuring of the earn-out.
“The perceived value of an enterprise from a seller / promoter’s perspective almost always is at variance from the valuation of the acquirer, thereby creating an impasse in negotiations or the acquisition process. Parties are increasingly seeking to bridge the gap by resorting to pragmatic measures such as earn-outs, where some part of the purchase consideration starts flowing in only after the deal closes, sometimes even a substantial portion. This, at least theoretically, gets the seller a price that is closer to what he feels is his legitimate expectation and protects the acquirer against the vagaries of future earnings.”
Pros and cons of earn-outs
These so called "earn-out" provisions detail the negotiated performance goals the successor company must achieve after "closing" to trigger additional payment obligations from the buyer to seller. A seller might rely on an earn-out to maximise consideration where he/she believes the future performance of the business will be substantially better than its historical performance. The buyer may be able to lower his/her initial cash outlay, avoid overpaying for future revenues, minimise the risk of losing key contracts and use earn-outs as an incentive to retain and motivate key personnel of the seller after closing. Properly drafted, earn-outs may provide incentives to continuing management and maximising value for both parties. There is also an opportunity for the buyer to become familiar with the business while it continues to be run by the seller.
For buyers, the purchase price can be limited to the amount for which they are certain the business is worth, and pay any excess only if and when the company meets those performance goals. In many cases, the future growth of the company provides a source of capital which it can use to pay the earn-out. One disadvantage for buyers is that earn-outs typically restrict the actions they can take with the target company during the earn-out period. This is because the seller needs to be able to retain enough of an interest to implement the strategies necessary for the promised growth.
For sellers, they are provide some breathing room in terms of timing and producing value. If the seller is certain that he or she can improve growth, then the earn-out allows him or her to receive value for that growth if and when it occurs. Many sellers mistakenly wait to sell because they want to book a great year of growth, but the earn-out structure allows an earlier, more effective exit.
Earn-outs in India
Earn-outs have been increasingly used as a tool in India for M&A deals for the last five years, of which an overwhelming majority of the deals have been cross-border deals. The same can be attributed to be on the insistence of non-resident buyers, who are comfortable with using earn-outs as a mechanism to bridge the gap in business valuation, on using earn-outs in transactions. Having said that, it should be highlighted that the existant foreign exchange regulations in India have played a major role in the structuring of earn-out mechanisms for cross border M&A deals.
As per the extant foreign exchange regulations, transactions contemplating payment of deferred purchase consideration for purchase of shares of an Indian company by a non-resident from a resident Indian require prior approval from the Reserve Bank of India (“RBI”). Therefore, the parties usually structure the mechanism for earn-outs in such a manner that it falls within the automatic route.
Earn-outs in India are typically structured in a manner such that the shares are transferred by the seller to the buyer in tranches linked to pre–agreed/anniversary dates depending on the achievement of certain milestones as per the performance metrics. However, given that the price for all transfers of shares in Indian companies (not listed on a recognized stock exchange) by residents to non-residents (including NRIs) must be equal to or greater than the price per share calculated in accordance with the discounted free cash flow method and certified by a SEBI registered Category I merchant banker or chartered accountant (“DCF Value”), the DCF Value will have to be factored in while calculating the number of shares to be transferred and/or the consideration payable in each tranche.
The price payable by the buyer for the shares in each tranche would have to be equal to or higher than the DCF Value applicable at the time of such purchase. Since there is a risk that the buyer would nevertheless be mandated to pay the DCF Value for each share sold in the respective tranche, which could be higher than the commercially agreed earn-out, the parties need to arrive at a commercial understanding in the earn-out mechanism to mitigate this risk. The parties also need to ensure that such mechanism of transfer in tranches should also be compliant with the legal requirement of sale of securities of a public company to be on a spot delivery basis.
Additionally, the parties may seek to secure performance of the other by using put/call options. However, the validity and/or enforceability of ‘options’ on shares of an Indian company in cross-border deals is not entirely free from doubt.
An alternative method used for structuring earn-outs is for the seller to transfer all the shares to the buyer and then enter into an employment agreement with the Indian company, under which the seller receives the earn-out payment in a staggered manner on pre–agreed/anniversary dates depending on achievement of certain milestones as per the performance metrics. A similar arrangement was considered by by the Authority for Advance Ruling (AAR) in Anurag Jain [(277 ITR 1), affirmed by Madras High Court (308 ITR 302)], wherein, the periodical payment of consideration was regarded as salary income in the hands of promoters.
Closing thoughts
Despite the inevitable conflicts, an earn-out can end up being a "win-win" situation for both the buyer and seller, if each party is prepared to compromise in order to implement a practical and commercial solution. Having said that, like all agreements, an earn-out agreement requires communication and trust between the parties, and therefore, is not risk-free considering the buyer may default or the seller may not perform as envisaged. However, attention to detail and providing adequate checks and balances, taking into consideration the aspirations of the parties, would go a long way in mitigating such risks. Moreover, removal of the requirement of prior approval of the RBI for deferred payment of purchase consideration shall be a positive step in encouraging the parties to effectively employ earn-out mechanisms in M&A deals in India.
Disclaimer–the views expressed in this article are the personal views of the author and are purely informative in nature.