One has witnessed, over the better part of the last two decades, a growing interest in sectors distinct from traditional sectors. More and more entrepreneurs and venture capitalists have shown eagerness to invest in riskier ventures, having potentially a higher rate of return on investments, but with little past records of performance. These start-ups, mostly in the high growth, but unproven, technology or entertainment sectors, have flourished, some have downed shutters, and while others have been bought out by larger companies and absorbed or merged with a compendium of products. A quick look at the buyouts currently taking place in the Silicon Valley area reveals hundreds of small ventures that have been bought over and absorbed by larger companies looking to cash-in on the unique services and products introduced by these start-up ventures. These ventures are essentially unmapped areas with a lot of their growth forecasts drawn from little or inadequate data and a heavy dose of speculation and optimism. An acquisition deal, therefore, in such new and unproven sectors, essentially hinges on the valuation of the company proposed to be bought which, in several cases, are in conflict with the parties’ estimation.
This valuation gap — the discrepancyin valuation of an enterprise proposed to be bought between the buyer and seller — is crucial to the deal. If this is not sorted out, there is a clear danger of the deal falling through or taking so long to close that the value that the parties hope to gain from it diminishes considerably. A valuation gap occurs because there is a difference between the optimism of the seller and the healthy pessimism of the buyer, both being perhaps not too off the mark in their respective assessments. Whereas a buyer’s valuation of an enterprise may be based on the earnings record of the past few years, the seller may base it on the massive growth prospectshe expects of the enterprise over the next few years.
Earn-Out Agreements are becoming increasingly common in acquisition of companies which are largely dependent on continued performance by individual promoters and/or key management team. From an acquirer’s perspective, the Earn-Out Mechanism facilitates a smooth transition of ownership and retention of the promoters with key management team for minimum defined periods. This also ensures that there is no disruption in the operations, post acquisition, given that the sellers are incentivized to continue to work and earn the value of the business. From a seller’s perspective, the preference always is to make clean sales. However, this does create an uncertainty as regards continuity with the business, given the change of status from ownership to employment. The Earn-Out Mechanism removes this uncertainty as the sellers continue to be the owners for a definite period of time and helps them achieve higher growth rate with the support of the acquirer. From an acquirer’s perspective, the key concerns in structuring the Earn-Out Mechanisms are the percentage of ownership transfer, immediately on closing and the earn-out period. Also, the acquirers need to build in adequate retention mechanisms for the key management team who may or may not be shareholders. Additionally, the acquirers need to carefully draft non-compete provisions so as to ensure that the sellers do not create competing businesses such that the business which has been acquired, itself suffers.
From a seller’s perspective, the concerns arise from the quantum of initial payments and the ability and certainty in respective of future payments. The promoters, who are deeply involved in the day-to-day running of the business, are concerned about their change of status from owner to co-owners/employees and the scope of termination of employment agreements, as also the corresponding effects on the Earn-Out Mechanisms on such situations. What is, however, material is for the parties to agree on an optimum earn-out period which, on one hand, would be adequate enough for the seller to perform consistently and on the other, be balanced with the cash-flow and expectations of the acquirer.
Every Earn-Out Agreement is structured around future earnings and, therefore, it is imperative that the mechanism for determining earn-outs is detailed upfront, including provisions for resolution of differences.
One of the ways to break such a deadlock is to enter into an Earn-out agreement. An Earn-out agreement can help in bridging this difference — the buyer agrees to pay a lump-sum amount to the seller that corresponds to the valuation of the buyer; and the rest of the amount, which corresponds to the valuation gap, is made payable subject to the enterprise achieving certain set financial/production targets over a period of time, usually not exceeding 3 years, but, not less than 1 year, though sometimes an Earn-out agreement may also extend to as much as 5 years. But, it has often been observed that these agreements are fraught with subsequent conflicts. An incomplete or vague agreement is a sure-fire way of inviting years of acrimonious litigation; and so is when the parties fail to understand the risks they are carrying upon them while entering into an Earn-out agreement.
For the seller, the most important aspect is to negotiate the largest lump-sum possible. Earn-out agreements often lead to bitter litigation between the parties because the parties had not thrashed out the details of the agreement properly. Firstly, it must be made clear if the earn-out targets are to be based on post-closing revenue, earnings (whether EBITDA, EBIT or net profit) or other criteria. Basing it on revenue or profit goals will eliminate certain accounting issues. Secondly, specific accounting principles must be agreed to by the parties to eliminate future conflicts arising out of accounting principles applied in determining revenues for earn-out targets. Long earn-outs, especially those of a 5-year term, are cumbersome and have little value as they are uncertain in theouter years because of the nature of discounted cash flows; and eventually may take the financial attributes of debt or equity.
Arrangements where the buyer wants the top management or promoters of the target company to remain with the company for a specified duration post acquisition are not uncommon in India. Generally, it is only in case of a hostile takeover that the existing management is substituted at the time of acquisition itself. The economic recession has led to increasing usage of Earn-Out Agreements due to uncertainty of returns and performance of the target company. Earn-Out Agreements provide a comfort zone to the acquirer during uncertain and/or volatile times.
One pitfall of an Earn-Out Agreement is the loss of managerial control and power of the seller which must remain with the company post acquisition. The foregoing directly impacts organizational metrics and increases the potentiality of psychological fallout between the seller and the acquirer or between the seller and existing employees of the target company. Additionally, if the seller is not part of managerial decision making, it may hinder the seller in meeting the performance targets to which the ‘earn-out’ is linked.
In an ‘earn-out’, ‘management control’ is an issue for the buyer as well as the seller. Buyers and sellers need to meet each other half-way to iron out ‘managerial control’ issues to mutually benefit out of the ‘earn-out’. Further, performance targets in an ‘earn-out’ must be clearly thought out in order to mitigate disputes at a later stage. Typically, performance targets are linked to profits, revenues or gross margins. Performance targets should be reasonable and at the same time promote the investment objectives of the buyer.
While use of the phrase ‘Earn-Out Agreements’ is not commonplace in the Indian context, the concept of ‘earn-outs’ forms a vital part of certain private equity and M&A transactions. As the current position stands in view of ruling, in the case of Anurag Jain vs. Authority for Advance Ruling and Another [(2009) 308 ITR 302], while lump sum transfer payments are eligible to capital gains tax, the ‘earn-outs’, being in the nature of contingent payments, will be taxable as ‘salary’ in the hands of the seller. Earn-Out arrangements still require deliberation at length from a taxation perspective to conclusively ascertain the taxability of contingent ‘earn-outs’ received by the seller.
A private equity investor, unlike a strategic investor, would want to retain the original management of the enterprise. This is because a private equity investor does not necessarily have an expertise in the specific industry and would want the old management to keep the reigns of the acquired enterprise. It becomes important for the sellers, therefore, to safeguard their earn-out payments in a situation where they have a significant, though relatively limited, role to play after the buyout. They must, first, nail down their position in the new company and obtain a proper employee contract signed. Secondly, they must have negotiated distinct, achievable earn-out targets. Then they must negotiate, and the Earn-out agreement must specifically mention, a ‘Best Efforts’ clause stating, among others, that:
The parties must also properly negotiate budgets for capital expenditures, research & development, advertising and maintenance; and also, if agreed to by the parties, stipulate that income calculation will not include overhead costs and depreciation. The agreement may also stipulate that the buyer will not club his products with those of the newly acquired enterprise; and in case the combined company is sold, then the sellers must have a stake in the proceeds of the sale.
It may also be the case that the buyer is not a private equity investor and has adequate knowledge and expertise of the specific industry. In which case, the seller may or may not be required to remain a part of the management. If the seller is not required to be part of the management team, he needs to ensure that those in the management do nothing averse that will affect the set targets of the earn-outs. Earn-outs are determined according to a sliding scale. Targets are spread across years and Earn-out agreements are usually drafted in a manner that payments are not often a percentage of the targets, if, the sameare tangible, but, are fixed payments upon the reaching or exceeding of specific targets. It is, therefore, important for the seller to negotiate smaller sliding scales for earn-out payments, as, often, with fixed revenue targets or large sliding scales, a small dip in profits can result in a massive cut in payments.
It is considerably easier to determine if the earn-out targets have been met, if, the enterprise is made to continue as a separate entity. It is common for technology companies to buyout start-ups for their nascent technological innovations and merge them with their own products and services. This, apart from adding value to the buyer’s existing product portfolio, can often also be crucial to the development of future products or the advancement or implementation of existing ones. In this case, the seller needs to ensure that the earn-out targets are discoverable from within the maze of revenue streams and product classifications.
For the buyer it is important that he and the seller are in consonance with the direction in which the buyer intends to lead the enterprise after the closing of the deal. A lack of cohesion on this issue, will lead to the seller declaring that the earn-out targets are being jeopardised due to the direction in which the seller expects to lead the enterprise to. Also, it is important that the buyer carefully looks at all the material aspects before determining his valuation of the enterprise. In case the valuation of the seller appears reasonable, there is certainly no pushing need to enter into an Earn-out agreement in the first place. Also, important is that the buyer must determine the role he expects the seller to play after the closing and if the management style of the seller is consistent with that of the buyer’s.
In an earn-out agreement the buyer pushes the envelope of risk towards the seller. Therefore, the risk is not equally shared between the parties. Clearly, in case the enterprise is successful post closing and the targets have been reached or exceeded, the seller stands to gain the earn-out payments, while the buyer gains from the increased profitability or the value that the enterprise brings to him. However, if the targets are not reached, then the seller stands to lose the earn-out payments and the buyer, depending on the number of targets hit or missed, may determine that his investment was a failure or partially successful.
Earn-outs must be for the benefit of both the parties to the agreement. Though in reality, the seller is the one taking the largest share of the risk involved. Earn-out agreements are entered upon to give due consideration for the seller’s forecast. They create a bridge that the parties can use to span their valuation gap and ensure that both the sides benefit from the sale. An Earn-out agreement may also contemplate a continuing association between the buyer and the seller. And, therefore, it must be negotiated with care and completeness to prevent and minimize any conflict or loss!
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