When the seller and buyer agree on the price, it’s the start of the transaction – not the end. Two additional components to the purchase price can add a twist and take quite a while to settle. It’s not uncommon for these components to drag on for months, and sometimes years, before resolution.

Balance sheet adjustments

First is a balance sheet adjustment, often connected to the working capital of the business being acquired on the completion date.

We’ve discussed this in detail here.

In its basic form, working capital refers to the entity’s current assets minus its current liabilities, usually adjusted to account for specific terms of the purchase agreement (such as excluding cash transfers from the seller to the buyer).

Purchase price adjustments related to working capital or other balance sheet metrics generally arise from disparities between the actual balance sheet at closing and the target metric agreed upon when the deal was initially reached between the parties.

Earn-outs and contingent payments

The second purchase price adjustment is an “earn-out”, which we have written about here and here.

In simple terms, earn-outs bridge any gaps between the desired selling price of the business by the seller and the price the buyer is willing to pay. They provide a certain level of assurance regarding valuation and the accuracy of the representations made during the negotiation phase of the deal.

Earnouts can be linked to a benchmark, whether financial or non-financial, or they can be governed by a formula, or sometimes a combination of both, for example:

  • Non-financial metric: the seller is entitled to receive an agreed-on additional payment should a specific non-financial milestone be met – such as a key contract being secured, or a regulatory licence being granted.
  • Financial metric: the seller is entitled to receive an agreed-on additional payment should a specific financial milestone be met – for example, EBITDA exceeds $X amount.
  • Financial formula: the seller will receive a defined percentage of the net income generated during an agreed period.

Reverse earn-outs (aka claw-backs)

Earn-outs can work in reverse.

Referred to as a “claw-back,” the seller assumes certain risks associated with the business’s performance after the transaction, such as a contractual provision where the seller is obligated to reimburse a portion of the purchase price to the buyer if the post-transaction EBITDA fails to exceed $10 million in the first year.

Limiting the upside and downside

Earn-outs can be subject to a “cap” or “collar.”

These impose a limit on the amount that can be received by one party and the corresponding financial liability of the other.

For example, the agreement might include a term stating that “the adjustment amount shall not exceed the adjustment cap.” In practical terms, this means that even if the formulaic calculation would allow for a higher refund of the purchase price, a cap of, let’s say, $1 million would restrict the buyer’s claw-back recovery to that specific amount.

Contract language is king

The specific calculation of the financial-formula earn-out or claw-back amount will be determined by the language detailed in the agreement.

Typically, the relevant provision will specify that the applicable measure (such as operating income) must be “prepared in accordance with the Accounting Standards”. However, the “Accounting Standards” definition, may allow for certain agreed accounting policies to trump the general standards, such as including specific revenues or excluding particular expenses.

Due to the numerous nuances and potential ramifications associated with the language about earn-out and claw-back provisions in agreements, it is critical for the parties involved in the transaction to ensure that their lawyers and accountants collaborate during the drafting and review process.

This should occur both in the initial stages and in the future should disputes arise. Professionals well-versed in these contractual mechanisms can identify ambiguous wording in the draft agreement that may give rise to uncertainties and conflicts when it comes time to perform the actual calculations. It pays to be proactive; that way, avoidable complications can be mitigated.

Takeaways

M&A advisers, accountants and lawyers with expertise in designing earn-out and claw-back structures and analysing and resolving related disputes play a crucial role in minimising the impact of unforeseen events. Their insights can prove invaluable when crafting these provisions, allowing parties to effectively anticipate and address potential issues.

Whether you are a buyer or a seller, you must seek the guidance of these experts when considering earn-out and claw-back terms, as well as the language of balance sheet adjustments and dispute resolution. By leveraging the advice of professionals, you will enhance the clarity and effectiveness of these provisions and mitigate risks associated with unforeseen circumstances.