In times of COVID-19, many transactions are difficult to negotiate, particularly when it comes to the purchase price. Can earn-out clauses be of any help? This is a question that needs to be answered separately and with caution in each individual case.
The current COVID-19 crisis has already demonstrated a lasting impact on the M&A market. Many companies, for example in the aviation, tourism, event and hotel sectors, are particularly affected. Generally, this is marked by an enormous financial burden. From the company's point of view, this can necessitate the search for a new investor or to divest less lucrative business units. Often, however, the originally envisaged purchase price is now out of proportion to the current value of the company, for example as a result of serious losses in turnover.
What are earn-out clauses? How are they structured in practice?
A solution may be found in earn-out clauses. Here, the buyer agrees to a variable amount in addition to a fixed purchase price, which is calculated depending on the future development of the target company. The earn-out only becomes due if a previously determined threshold value is reached within a certain period. Points of reference may for example be, certain milestones with importance for the company (e.g. market maturity of new technologies or products, achievement of a predefined customer base) or the achievement of certain financial key figures. In the cases at hand, often the prior strength of the company and its original turnover are utilized as the point of reference. In 2019, the latter was indeed the case in 40 percent of the 466 transactions managed by CMS in Europe.
On the contrary, if the threshold value is not met, often the seller leaves empty-handed – even if only just falling short of the agreed threshold value (so-called all-or-nothing clause).
In 2019, an earn-out was agreed in every fifth transaction managed by CMS in Europe. In 60 percent of the cases, a reference period of 12 to 36 months was stipulated and in 17 percent of cases more than 36 months.
When drafting a contract, particular attention should be paid to the calculation of the threshold value ensuring it is as clear as possible. Otherwise, post-M&A disputes are inevitable.
Question: Do earn-out clauses provide a way out in any case or specifically due to COVID-19?
At first glance, an earn-out agreement may appear to be the answer to the uncertainty triggered by the COVID-19 pandemic and the slump in sales of many companies in M&A situations. In addition to bridging diverging purchase price expectations, the seller may participate in the desired positive development of the target company beyond closing and on the return to normality. If keeping the seller on board is important, this may create strong incentives. This may particularly be the case in PE transactions, partial sales, buy-back models, joint ventures or the sale of start-ups.
Answer: Only partially.
One should always bear in mind, however, that after closing, the seller usually does not have the power to influence the further course of business of the target. The buyer is thus generally able to influence the threshold value calculation (on the advantages and disadvantages of earn-out clauses see also Meyding/Grau, NZG 2011, 41, 42). The risk of manipulation and legal disputes linger. Although these risks may be counteracted by contractual agreements, this often requires the continuation of the company on a standalone basis and makes post-merger integration into the buyer's group more difficult. In addition, there is the risk that the seller will refrain from any participation after closing, if it is clear that the relevant threshold value will not be met or, conversely, has already been achieved. The latter is conceivable if the reference level was set too low because the effects of COVID-19 were under- or overestimated. Against this background, particularly the abovementioned all-or-nothing clauses are not without risks.
Flexible earn-out clauses
In order to effectively counter the uncertainties associated with COVID-19, a flexible earn-out clause seems useful in certain cases. Such takes the uncertainties of the COVID-19 crisis into account as follows: instead of an all-or-nothing clause, an agreement may be reached in which different thresholds are considered and where the earn-out is payable in staggered instalments. Due to the different threshold levels, the risk of the transaction, the future development of the target company and the overall economic situation is adequately distributed between both sides. In addition, should the seller continue to be bound to the company, this will maintain the incentive for the seller to remain fully committed to the target during the phase of integration.
Given the inherent uncertainty of the length of the COVID-19 pandemic and the ambiguity surrounding its economic impact, it would not be surprising if earn-out periods were extended in the future. It is also to be expected that EBIT / EBITDA-based earn-outs will decline in favour of turnaround-based earn-outs, as was the case during the financial crisis in 2008. Only time will tell whether a strong increase in earn-out clauses will also be observed in future, which would reproduce a similar development as during the financial crisis in 2008. Currently, at best only a moderate increase may be observed. This is also due to the risks and disadvantages described above. Therefore, the motto is "often negotiated, rarely agreed".
On the possibilities of earn-outs in the acquisition of distressed companies, especially in the automotive sector, see the blog post "Earn-out in distressed M&A in the automotive sector" (in German).