Earn-Outs In M&A Transactions
The essence of having a deferred component is to ensure that the sellers remain interested in the affairs of the target entity and it is expected that by the completion of the deferred period, the buyer understands the nuances of the business of the target entity for which he has paid for.
Purchasers in an M&A transaction may not have complete visibility of the affairs of the target entity prior to closing. Largely, the purchasers rely on information, documents, and representations provided by the sellers/ target and therefore, intend to hedge their risks for uncertain events.
One option for hedging the risk is to have a deferred component in the purchase consideration a practice that gained prominence from 2016. Until 2016, Indian exchange control requirements mandated prior approval of the Reserve Bank of India (RBI) if a share purchase transaction involved deferred consideration involving the transfer of shares by an Indian resident seller to a non-resident acquirer. RBI liberalised this requirement, by permitting payment of deferred consideration with a condition that the aggregate deferred consideration does not exceed 25% of the total consideration and the deferred period does not exceed eighteen (18) months from the date of the agreement. Nearly 8 years after the amending of the exchange control regulations, the majority of the cross-border transactions now feature deferred component.
The essence of having a deferred component is to ensure that the sellers remain interested in the affairs of the target entity and it is expected that by the completion of the deferred period, the buyer understands the nuances of the business of the target entity for which he has paid for. Deferred consideration forms part of the purchase price for shares and therefore will be subject to exchange control requirements including the maximum permissible time limit of 18 months.
Alternatively, the ‘earn-out’ model can also be structured by linking the payments to certain pre-determined milestones, and outgoing sellers are entitled to such payments by their continued employment and not on account of shares held by them in the target entity. The pre-determined targets can be related to financial, operational, or management activities, and most of the time it is linked to achieving a certain level of EBITDA. In research-intensive or product-based entities, earn-outs are also linked to aspects like the development of a new intellectual property or rolling out a new product into the market.
For example, the outgoing shareholder can continue as a managing director and will be eligible for payments say in three installments over the next three financial years, provided the target entity achieves pre-agreed EBITDA in each of the financial years. Sellers may note that under the ‘earn-out’ model, the payment is considered as salary and will accordingly be taxed.
While agreeing to EBITDA-linked earn-outs, care should be taken in defining EBITDA. It is often the case that expenses under certain heads are bound to increase for the target entity for implementing purchaser-mandated policies and procedures. Similarly, for implementing remedial measures against non-compliances identified in due diligence there can be additional expenses.
Seller usually expects the expenses towards compliance with activities mentioned in the transaction documents to be added back to arrive at EBITDA numbers as these are one-off expenses as a result of the transaction while a purchaser expects this as an obligation of the seller and may want to not include the same to arrive at EBITDA numbers. This can be a key negotiation aspect when dealing with ‘earn-outs’ linked to EBITDA. It is often the case that parties may agree on different accounting principles for arriving at EBITDA numbers for the purpose of ‘earn-out’ payments than those followed for maintaining the financials of the target entity.
Further, in an EBITDA-linked earn-out model, the sellers when in control of the target may decide to reduce the expenses or defer certain expenses to achieve the EBITDA numbers which the seller will not be comfortable with. Therefore, from a buyer’s perspective appropriate provisions must be incorporated into the transaction documents to ensure that affairs of the target are prudently conducted in the usual course and prevent artificial measures to achieve EBITDA numbers.
A benefit for a foreign purchaser in an ‘earn-out’ model is the easier recovery options by way of clawback. Since the payment is made by the target entity on account of employment, a clawback of benefits will be a domestic transaction without involving exchange control regulations.
It is also worth noting that while employee clawback is untested in the Indian scenario, the Companies Act, 2013 enables recovery of remuneration (including stock options) from the Managing Director, CEO, and Whole-time director on account of re-statement of its financial statements due to fraud or non-compliance with any requirement under the Companies Act during their tenure.
As ‘earn-out’ is based on the employment of the seller/seller group, from a seller perspective, it must be ensured that no termination for convenience clauses are included in the employment agreement, and care should be taken to ensure the seller is not disentitled to earn-outs due to actions attributable to the purchaser. From a buyer’s side, it must be ensured that the seller does not abandon the employment and earn-out incentivises a smooth transition, so that the value of the target can be protected. Any exit of the key employees may lead to the value destruction of the target. On the other hand, as earn-outs are performance linked be it EBITDA or other pre-agreed KPIs, the sellers must ensure they have sufficient control over the achievement of the pre-agreed metrics.
Further, it is also a common phenomenon that by the end of the earn-out period the purchaser may expect the seller to sell all his remaining shareholding to the purchaser if there is no complete exit to the seller in the first instance. While things may be implemented as documented, contingencies for earn-out linked targets not having met must be considered in the transaction documents.
A strategic buyer may not want to continue if the entity fails to achieve the pre-determined earn-out linked targets after having given sufficient time while the seller who by this time will only be a minority shareholder cannot always have the financial strength to buyout the purchaser stake. In conclusion, drafting earn-out related provisions necessitates a comprehensive view of all potential consequences and requires the inclusion of robust safeguards depending on the party we represent.
Disclaimer – The views expressed in this article are the personal views of the authors and are purely informative in nature.