Earn outs – has COVID-19 caused a problem?

The economic impact of Covid-19 has been well documented in the media, and there is currently significant uncertainty both in terms of the timescale and shape of the recovery, and also whether the pandemic will lead to permanent structural changes in some areas of the economy.

The above can potentially raise significant issues for sellers who have recently sold, or who intend to sell their business using an earn-out structure.

What is an earn-out?

Earn-outs have been a common feature of M&A transactions, with increasing numbers of transactions using some form of earn- out structure.

Consideration received for the sale of a business can be split over time, with an amount due on completion, and further amounts deferred to a later date.

The deferred element of the consideration is often contingent on certain conditions being met, and where these contingencies relate to the business achieving certain performance targets in the post- acquisition period, the deferred consideration is commonly referred to as an ‘earn out’.

Earn-outs are particularly useful in bridging a valuation gap between the acquiror and seller. This can arise due to different views on the future performance of the business, and the degree of risk attached to the forecast performance of the business. On this basis, it may be expected that earn outs become even more popular in future years.

Earn-out periods typically range from 1 to 4 years, thus providing the sellers with an opportunity to demonstrate the value of the business (often through retaining an active role in the business), and therefore receive an increase in their consideration as the future performance is delivered.

The potential impact of Covid-19 on earn-outs

Covid-19 is likely to have impact on earn-outs in a number of ways. The impact is likely to be felt in three key areas:

Financial performance

Perhaps the most obvious impact is likely to arise from the impact of Covid-19 on the financial performance of the target business.

Earn-out payments are typically linked to the financial performance in each year of the earn-out period. It is therefore likely that if the business has been adversely impacted by Covid-19, the earn-out payments relating to this year’s performance (and possibly future years) could be significantly reduced.

Potential solutions could include an extension to the earn out period, or the inclusion of adjustments to amend performance to mirror actual underlying profitability. This will need to be negotiated across all parties with a careful focus on affordability, and reference back to the original legal agreements documenting the basis of the sale. Any proposed changes to an earn-out should also be considered from a tax perspective to ensure that they don’t affect the tax treatment. However, there may also be an opportunity to claim tax back now if proceeds have been taxed but will not in fact be paid.

Demotivated management

It is important to note that a missed Earn-Out target is potentially a significant issue for the Purchaser as the business they have acquired is now underperforming. Faced with a significantly reduced earn-out payment, possibly coupled with a perception that earn-out targets in future years are now unachievable, sellers may lack an incentive to ensure that the profitability of the business, or the division of the business which they control, is maximised.

If this issue is not addressed this could, in some cases, lead to the resignation of the seller, which could have a de-stabilising effect on the business.

Cash flow and the funding earn-out payments

For businesses sold prior to Covid-19, and where earn out payments are now falling due, if the Purchaser is experiencing cash flow issues arising from the pandemic they may be unable to pay the earn-out payments on time.

An extension to the time frame for payment, additional interest charges, or the use of alternative forms of consideration such as equity or loan notes may need to be considered.

The solutions to the above issues all involve discussion and negotiation between the parties and their advisers. Most share purchase agreements can only be varied in writing, and therefore any changes to the earn-out structure or payment terms would need to be properly documented. However in most cases it will be in the interests of both parties to swiftly reach a suitable compromise.

Refinancing of earn out payments will be extremely unlikely via external debt as existing government backed loan schemes generally cannot support this, albeit for those with strong underlying performance and an ability to demonstrate a fair risk profile (perhaps as the earn out period is close to finalisation) may be able to source new debt facilities to replace these.

Contact us

For further information, please contact Lee Humble, Corporate Finance Associate Partner at lee.humble@taitwalker.co.uk.