Earn-out in the event of a takeover: the position of the former director and major shareholder

An earn-out in the event of a company takeover offers opportunities and risks. The former director and major shareholder remains involved in the company and part of the purchase price remains dependent on future performance. What aspects are important here?

When acquiring a company, it may be wise for the former director and major shareholder (DMS) to remain as a director after the purchase. First of all, the former DMS remaining is important for the continuity of the company. After all, they know the company like no other. Retaining the DMS’s knowledge of customers, suppliers, and internal processes can be crucial for successful continuation. This is valuable for the buyer because it increases the company’s chances of growth. In practice, the remaining in office of the former director is often linked to an earn-out.

What is an earn-out?

An earn-out is an agreement whereby part of the purchase price in a takeover is made dependent on the (future) performance of the company. The unpaid portion is only paid once the company achieves the expected results. It is important that concrete agreements are made about the objectives. Commonly used parameters are turnover, EBITDA (earnings before interest, taxes, depreciation, and amortization), or customer retention. The earn-out period, during which these targets must be achieved, usually lasts one to several years, depending on the agreements.

Advantages of an earn-out

Advantages for the buyer

• Risk management: The buyer pays part of the purchase price only if the company has achieved the set performance targets. This limits the risk of the buyer paying too much for a company that does not meet expectations.
• Flexibility in financing: With an earn-out, part of the purchase price is deferred. The buyer then needs less available capital and therefore has to finance less to complete the purchase.
• Expertise of the seller: An earn-out incentivizes the seller to commit to achieving the agreed business objectives, as part of the purchase price depends on their performance.

Advantages for the seller

• A higher sale price is possible: One of the most important advantages of the earn-out for the seller is the possibility of receiving a higher sale price when selling the company. Because part of the purchase price depends on the performance of the company, the seller can benefit from growth in profits during the earn-out period.
• Flexibility in negotiations: If the buyer and seller disagree on the value of the company, the seller can use the earn-out to still receive a guaranteed amount for the sale without the negotiations breaking down. If the company performs well during the earn-out, the seller can still receive the asking price.
• Involvement in the company: An earn-out gives the seller the opportunity to continue to play an active role in the company. This allows the seller to influence the strategic direction of the company.

Some points to consider

Conflicting interests in the earn-out

Accepting the earn-out implies that the former director and major shareholder (who is now a director) has confidence that the agreed targets are achievable. The pitfall, however, is that this person has a dual role: on the one hand, as a director who must serve the interests of the company, and on the other hand, as the seller who has a financial interest in achieving the earn-out targets.

Disagreement about targets

Another sticking point arises when there is disagreement about the earn-out targets. If these targets are not measurable and specifically laid down in the agreement, disputes may arise about whether the targets have been achieved. It is important to make specific agreements about, among other things, the targets set, the duration of the earn-out period, the method of monitoring, and the method of dispute resolution.

Disagreements about tasks

Another stumbling block in an earn-out can be that the buyer and seller may disagree about how the company should be managed. The seller will mainly focus on achieving the earn-out targets quickly, while the buyer may have a long-term vision. Clear agreements about tasks and responsibilities are therefore crucial.

Corporate and contracts lawyer

Would you like to know how to record agreements about an earn-out in such a way that the risks are limited? Please contact us. We are happy to think along with you and help you avoid risks.