What is an “Earn-Out” Provision?

An “earn-out” provision is a method of measuring part of the purchase price for a business based on its financial performance after the closing date. Earn-out provisions are common where the seller continues to be involved in the business after closing, and they provide an efficient way for the seller and the buyer to share post-closing operating risk by aligning the seller and the buyer’s post-closing incentive for the business to continue to succeed.

Earn-out provisions also give the seller an incentive to provide the buyer with all available information, both good and bad, about upcoming events. Earn-out provisions also encourage the seller to help with the transition of the business to the buyer, especially the transition of customer relationships. Finally, earn-out provisions discourage the seller from “puffing up” the business’ past financial performance, since the earn-out will usually be tied to the performance measures that the seller provides.

Since earn-out provisions are usually are based on projected revenue or profits, the seller and the buyer, and especially their attorneys, should be careful to clearly define the revenue and expense accounts that will be counted toward the earn-out benchmarks. Not only will the revenue and expense accounts require attention, but the timing of when revenue is earned and when expenses are deducted must also be addressed. These definitions and procedures can become even more difficult if the buyer intends to operate the business that it is buying as a part of a larger enterprise.

Since an earn-out will mean that a buyer will pay more for a business if it performs well, a seller may blame the buyer for running the business poorly if the earn-out targets are not met. A seller may also say that the buyer didn’t invest enough time or money in the business for the business to meet its potential. To avoid this problem, the earn-out agreement should address whether the buyer is obligated to operate and support the business in a manner consistent with its history or at a certain level.

What are “Caps” and “Baskets”?

“Caps” and “baskets” describe concepts that are used to simplify the administration of the liability and indemnification sections in a purchase agreement after the sale has closed and the buyer is operating the business. “Baskets” are designed to have the parties avoid petty squabbles over minor disputes after the closing. A “basket” agreement will usually say, for example, that a buyer cannot sue the seller for damages for a breach of any term, warranty, or representation in the sales agreement until the total damages exceeds a minimum threshold such as 1 percent of the purchase price.

A “cap” limits the amount that the buyer can seek to recover from the seller for a breach of the terms, warranties, or representations of the sales agreement, such as 10 to 25 percent of the purchase price. A cap helps the seller limit the uncertainty about whether they will have to refund the purchase price. A cap also encourages the buyer to perform thorough due diligence because the buyer will not be entitled to a full refund if the business fails to meet expectations, unless the seller committed fraud.

Who is Giving the Indemnification?

If the seller is a corporation that will distribute the sales price from selling its business assets to its stockholders, the corporation may have few assets left after the sale for the buyer to go after if the business assets fail to perform as expected. If the buyer’s only indemnification rights are against the selling corporation, the buyer may be chasing a bankrupt entity.

If the buyer is purchasing stock from numerous individual stockholders and the purchase agreement provides that the individual stockholders will be severally liable instead of jointly liable for indemnification obligations, the buyer may find itself chasing many individuals who have already spent the money they received from the sale.

When an individual stockholder is wealthy enough to reassure the buyer of its ability to indemnify the buyer, the purchase agreement may provide that the buyer can sue the wealthy stockholder individually for all breaches of representations and warranties. In this case, the wealthy stockholder may enter into a side agreement with the other stockholders whereby they each agree to remain liable to reimburse the wealthy stockholder for their individual share of any indemnification obligation.