[EP 012] Earn-out Arrangements: The Tips, the traps and everything in between with Elizabeth Lee

Joanna: Hi it’s Joanna Oakey here and welcome back to The Deal Room Podcast. Today we have the fabulous Liz Lee with us again to talk about the area of tips and traps for earn-out arrangements. Hi Liz, thanks a lot for coming back again.

Liz: Hi Jo, thank you for having me.

Joanna: Great. All right so look, I guess this area of earn-out arrangements is really typical in the sales and acquisitions space because lots of buyers like to purchase on the basis of using an earn out as a way to either have deferred payment or some sort of protection for them in relation to the amount that they’re paying and sellers on the other hand feel often quite anxious about earn-outs as a whole.

Liz: Yes, and often I think purchasers will offer to buy a company or business using the earn out mechanism to offer more for the business.

Risks relating to earn-out arrangements

Joanna: Yeah. So it’s an opportunity, isn’t it? If sellers can get their head around it, then it can be an opportunity for them to potentially get a higher value and sometimes also open up the range of who might be sitting out there as a buyer that might be interested in their business. I guess that’s the positives but whilst there’s positives I guess there’s also risks. So what do you see as the real risks for sellers looking to adopt an earn out arrangement as part of the transaction fee?

Liz: Yes, so there are also elements that could be taken into consideration for earn-out arrangement from a vendor’s perspective, and the seller’s perspective. They need to know that this is for the vendor to earn the earn-out because once they’ve sold the business, they have given control of the business to the purchaser, essentially. There may be ways to try to limit that control but at the end of the day once the vendor has sold, it’s a risk for the vendor. So therefore the vendor needs to be very clear about the protection mechanisms that they want included in the sale and purchase agreement.

Ways to structure earn out arrangement clauses to protect either buyer or seller

Joanna: Absolutely, that’s a really good point. OK. So, let’s talk about some ways that we might protect sellers in this environment in the documentation, I guess it might be useful for people to understand some of the ways that you can limit the control that a buyer has.

Liz: Yes, that’s right. So there’s operational controls: who’s going to be running the business, what parameters are there going to be in running the business, is there a business plan that they’re going to go with, can the purchaser radically change the strategy of the existing business? So you’ve got these overarching structural type operational controls that the vendor might want to impose on the business going forward. There’s also the issue of financial contribution. Will there be sufficient resources and a working capital provided by the purchaser for the business to realise its potential? So those two elements are really important.

Joanna: Absolutely.

Liz: And also, certainty as to staff who have stayed on, remained with the business. You want to have protection about this ongoing human resources that will be supporting the business too.

Joanna: Yeah. Nothing like the key staff. Not getting the raise that they are expecting the next year and then racing off and then suddenly your whole prospect of getting your earn out diminishes with staff member that run off. So I guess also there’s this whole concept of credit risk exposure. Can the new entity pay and indeed how is it that you force payment. So that’s something that is always important to work through as well.

Liz: Yes, absolutely.

Joanna: And there’s ways that you can, bearing in mind that exposure, you also then need to think about how far you want to go in protecting your position because there’s many potential protections that you can build in place but you have to work out whether or not you want to register on the PPSR and how far you want to take this protection.

Liz: Yes, well there’s a fine balance between protecting the vendor and compromising or capturing the purchaser’s right to own the business and to operate it in the way that it wants to as well. It’s actually a really fine balance there.

Joanna: Yeah that’s a good point because a part of what we’ve been talking about has been from the seller’s perspective but from a buyer’s perspective they’re walking into this earn out arrangement as a way that they can perhaps protect a bit of their risk in the purchase in relation to how much they’ve paid for the business to make sure it is adequate in relation to how much the business is earning going forwards. But of course they themselves don’t want to be completely hamstrung by the earn out arrangements that are in place so that they can’t run the business the way they think it should be run.

Liz: Yes, that’s correct because whilst the purchaser might offer to purchase a business on that basis at the same time the purchaser’s got to be careful as to these issues that the vendor might break down and string them in relation to having owned the business.

Joanna: Absolutely. And I guess the last item here that should be considered is what about unexpected events because I guess this is something that has to be borne in mind by both parties, like death or some sort of TPD event. So what’s the suggestions we can give our listening audience about the sorts of things to think about that?

Things to consider on unexpected events

Liz: Some of the mechanisms that are often used to the concept of there being an accelerated payment due to an unexpected event happening like this. I mean this is something that occurs beyond the vendor’s control, with the death or TPD. And therefore, should the vendor really be penalised for something like this that occurs, that’s beyond their control. So you could work in a regime of accelerated payment to the vendor’s estate. It’s unfortunate for the purchaser and therefore there might be ways in which to hedge that risk such as insurance policies and so forth. So, they’re ways to deal with this type of risk.

Joanna: Great. OK. All right. Well look I think that’s a good quick snapshot. Maybe in the future we’ll do another episode where we really drill into some of these areas in more detail. But today was really just about giving a quick overview for organisations that are looking to buy or sell and considering whether or not earn out arrangements are something that they might want to consider as part of the structure of the sale price so we just wanted to cast a bit of light. So there were some fair understanding of the pros and cons of incorporating earn out arrangements.

Quick recap

Joanna: So as a bit of a recap, we talked about earn-out arrangements and some of the risks that can relate to earn-out arrangements. And also some of the ways that you can structure these earn out arrangement clauses to protect yourself whichever side of the fence you’re sitting on. So if you would like more information about this topic head over to our website at thedealroompodcast.com where you’ll be able to download a transcript of this podcast episode if you’d like to read it in more detail. There you’ll be able to find details of how to contact Liz Lee if you’d like to discuss the potential sale or purchase of a business. And we also have a great number of services that help businesses both prepare for a sale or acquisition to help them prepare in advance and to get transaction ready. We also have a range of services to help guide businesses through the sale and acquisitions process.

We work with clients both big and small and have different types of services depending on size and complexity. So don’t hesitate to book an appointment if you want to find out more about how we might be able to assist you or your clients. And finally if you enjoyed what you heard today please pop over to iTunes and leave us a review. Thanks again for listening in to The Deal Room Podcast. You’ve been listening to Joanna Oakey and Elizabeth Lee. See you next time!