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Earn-outs – what are they and when are they used?

Earn-outs – what are they and when are they used?

Of course it is always a vendors preference to receive the consideration in full on the sale of their company. In rare circumstances this can be achieved but more generally it would require a proportion of deferred consideration. This is especially true in the case of a management buyout (“MBO”) where funding for a deal is predominantly being raised secured on the company’s balance sheet and projected future cashflows.

In the case of an MBO, business cashflows may be insufficient to support capital and interest repayments on the amount of debt which would otherwise be needed to pay the vendor in full at completion. Furthermore, funders gain comfort from the vendors’ financial endorsement of a management team.

Deals can be structured to include a fixed level of deferred consideration payable to the vendor on terms which are not linked in any way to business performance following its sale. They can also be structured to involve an earn-out arrangement. Under an earn-out additional consideration is payable to the vendor contingent on the future trading performance of the business.

A vendor may have reason to expect profits to grow after completion as a direct consequence of work carried out pre-completion, for example a lucrative contract with a new customer may have been won shortly before the sale. An acquirer may only wish to pay consideration at completion based on historic performance to date, especially if a company’s profits have been flat for many years and are forecast to jump up.

An earn-out provides an opportunity to receive additional consideration if the company’s performance improves as anticipated, but provides comfort to the acquirer that additional consideration will only crystallise if the forecasts are achieved or surpassed.

Author – Chris Summerscales, Head of Origination, Seneca Corporate Finance

The Seneca team have a wealth of experience in helping vendors structure suitable earn-out mechanisms which minimise the risk of achieving deferred or earn-out consideration.

If you would like to get in touch with our Corporate Finance team then please call them on 01942 295 983.

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