It is no secret that every facet of the economy’s workings has been disrupted as a result of the pandemic. Mergers and acquisitions are not immune to the changing climate, and there are several aspects of deals that were otherwise running smoothly that need to be re-evaluated in an effort to allow the parties to proceed in a fair and equitable manner. One of the more obvious ones is that of the purchase price–both sides must examine their valuation methods to ensure that the right price is agreed upon. A concept known as an earn-out can be quite useful in such unavoidable circumstances.
An earn out is a relatively simple concept–essentially, it is a contractual provision wherein which the two parties involved agree that a certain price will be paid at the time of the merger or acquisition, and the buyer is obligated to pay a certain share of his/her profits (if the business reaches a certain level of profitability, that is), which is usually a percentage of the expected gross profits of the company. For instance, an agreement can be reached where the buyer pays $2 million upfront in addition to 5% of the company’s profits for 5 years after the sale.
There are several pros and cons to this type of setup–first, the seller can benefit from tax advantages as a result of the sale being spread out over a longer period of time. On the same note, the buyer can benefit from the extra time to produce the extra cash, especially if they did not have the means to put down the necessary amount of money in the first place. However, the buyer may not welcome the seller’s potential interference with the business during the payout period. Also, the company may simply not become as profitable as anticipated, thus resulting in the seller acquiring less money than if the earn out never happened.
That being said, an earn out is perhaps the only hope of a merger or acquisition going through, particularly at a time like this. Valuation gaps could be bridged and contracts could be negotiated so as to ensure that the chances of future disputes are mitigated. It is important for both parties to be flexible and open in the wake of the changing economic climate to ensure that the transaction is negotiated successfully.