Earn-Out Consideration

Earn-out consideration is a deferred and conditional element of the purchase price in the sale of a company or business. The buyer pays an initial amount at completion and promises further payments later if the acquired business achieves specified results, such as a level of revenue or profit, or a defined event such as a regulatory approval. If the targets are missed, the additional amount is reduced or not paid at all. The seller thus earns part of the price out of the business's future performance.

Earn-outs are a common feature of mergers and acquisitions, particularly private company sales, and they sit alongside other price mechanisms such as a purchase price adjustment based on completion accounts. The difference is that those mechanisms correct the price for the position at completion, whereas an earn-out depends on what happens afterwards. Accounting standards call it contingent consideration.

The main purpose is to bridge a gap in valuation. A seller may believe strongly in forecasts that the buyer finds uncertain, as with a young, fast-growing company, a business dependent on a new product, or one recovering from a downturn. An earn-out lets the buyer pay the higher price only if the forecasts prove right. It also defers part of the cash cost of the acquisition, and it gives sellers who stay on as managers a direct incentive to deliver growth. Earn-outs become more frequent when markets are uncertain and financing is expensive, and they are especially common in life sciences, where payments are tied to clinical and regulatory milestones.

• The metric. Revenue is simple to measure and hard to manipulate but ignores profitability. Profit measures such as earnings before interest, tax, depreciation and amortisation reflect value better but depend on accounting choices and cost allocations. Non-financial milestones suit some sectors.
• The period. Earn-outs typically run from one to three years after completion, sometimes longer for milestone-based deals.
• The formula. Payment may be all-or-nothing on reaching a threshold, or scaled, for example a multiple of profit above a base, usually subject to a cap.
• Accounting basis. The agreement fixes the accounting policies to be used, often those applied by the target before the sale, and lists specific adjustments.
• Conduct of business. Covenants govern how the buyer may run the business during the period, since its decisions on pricing, investment, staffing and integration affect the result.
• Acceleration and security. The seller may negotiate full payment if the buyer sells the business or breaches the covenants, and protection such as a guarantee or an amount held in escrow, comparable to an escrow holdback.

Under IFRS 3 on business combinations, the buyer recognises contingent consideration at its fair value on the acquisition date as part of the price paid, which affects the amount of goodwill recorded. An obligation to pay cash is classified as a financial liability and remeasured at each reporting date, with changes going through profit or loss; an obligation settled in a fixed number of the buyer's own shares may be classified as equity and is not remeasured. United States accounting rules follow a similar approach. Estimating the fair value calls for probability-weighted or option-based models and usually relies on unobservable inputs, placing it in the lowest level of the IFRS fair value hierarchy.

One distinction is important. If payments are forfeited when a selling shareholder leaves employment, the standards generally treat them as remuneration for post-acquisition services and not as part of the purchase price, so they are charged as an expense over the period.

The tax treatment depends on the jurisdiction and the drafting. Authorities may tax the seller on the estimated value of the earn-out right at completion, or as payments are received, and may treat sums linked to continued employment as employment income instead of capital gain. Parties usually take advice on how the structure affects the timing and character of the seller's tax and the buyer's tax basis in the business.

Earn-outs are a frequent source of post-deal litigation. Sellers complain that the buyer depressed results by loading costs onto the business, diverting customers to other group companies, changing strategy or delaying sales until after the period. Buyers complain that managers chased short-term results at the expense of long-term value or integration. Courts generally hold buyers to the express covenants and, in some jurisdictions, to an implied duty not to act in bad faith to defeat the earn-out, but they are reluctant to impose obligations the contract does not state.

Careful drafting reduces these risks: precise definitions, worked examples of the calculation, access to information for the seller, and referral of accounting disagreements to an independent expert. Some parties avoid the problem by agreeing a fixed deferred payment, a seller loan note or retained equity instead. In deals priced under a locked box mechanism, an earn-out can still be added as a separate element. Earn-outs also appear in a buyout transaction led by private equity and in acquisitions of start-ups backed by venture capital.

• IFRS Foundation: IFRS 3 Business Combinations