December 7, 2020
Locked-box pricing mechanisms in private merger and acquisition deals have been popular in recent years. The mechanism, in short, involves the buyer and seller agreeing on a fixed purchase price at the start of the transaction, based primarily on the last audited accounts of the target entity, and the forms of financial leakage since the date of such accounts that are reimbursable to the buyer. This pricing mechanism incentivizes the buyer and the seller to finalize the transaction documents in a cost-effective and timely manner and provides both parties with a level of certainty concerning the price of the target.
However, a downside of the locked-box pricing model is that the buyer, having paid for the target entity up front, shoulders the risk of it underperforming post-completion. Under normal economic circumstances, this may be a risk the buyer is willing to take in exchange for a relatively swift acquisition, particularly if it has good warranty coverage and has carried out a thorough due diligence exercise. However, with the end of the Brexit transition period nearing, ongoing U.S.-China trade hostilities, the fallout from the COVID-19 pandemic and the rising concern of a global recession, buyers may be encouraged to shift away from locked-box pricing structures and toward more risk-averse pricing mechanisms like the earn-out model.
An earn-out mechanism involves the buyer paying an amount on completion and agreeing to make certain top-up payments at a later date, or dates, subject to the target entity satisfying certain performance targets post-completion. The earn-out payment(s) are usually tiered so the better the target entity performs over the agreed earn-out period, the more the buyer pays toward the purchase price.
For buyers who are concerned about committing to an acquisition during this uncertain time, an earn-out pricing mechanism mitigates the risk of overpaying for a target entity that turns out to be less profitable than envisaged. For sellers looking to entice buyers, offering an earn-out pricing mechanism may help to drum up interest at a time when M&A activity may slow.
There are issues to consider, however, when opting for an earn-out mechanism. To oversee the satisfaction of the performance targets that trigger the purchase price top-up — i.e., the earn-out payment(s) — it is typical for the seller to remain involved in running the business after the acquisition has completed. Keeping an incentivized seller onboard during what could otherwise be a complicated transition period is often desirable; however, there can be conflicts of interest that must be accommodated in the purchase agreements. Unchecked, the seller may, for example, seek to inflate short-term profits or revenues for the sake of satisfying the earn-out targets, whereas the buyer may want to take a longer-term view.
There is also a balance to maintain regarding the level of management power the seller is granted post-completion. The seller will not want to be restricted in the way it attempts to satisfy the earn-out targets, but the buyer will want to maintain control over key decisions now that it owns and must stand behind the target. Furthermore, when agreeing on the earn-out performance targets, the buyer will need to consider the extent to which the seller should benefit from any improvements in the target’s performance that are the result of the buyer’s efforts or input. The buyer may, for example, bring economies-of-scale efficiencies, providing intercompany services or infrastructural improvements that boost the target’s profits. If these issues are not correctly accommodated in the underlying purchase documentation, disputes may arise over whether, or how much of, an earn-out payment is due.
Overall, it is clear why earn-out pricing agreements might become more and more popular in private M&A. In a market that typically follows the principle of “caveat emptor” (“let the buyer beware”) and places the onus on the buyer to conduct thorough investigations into the target, will economic uncertainty turn the tables? If sellers want to avoid a stagnant economy, they may have to consider pricing methods that are more attractive to buyers. That is not to say the seller must lose out. If approached in the right way, earn-out pricing agreements can be an easy way to make sure both parties leave the negotiating table as winners.