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EARN-OUTS & CLAWBACKS: How to bridge a purchase price gap

A lot of deals fall through during initial negotiations due to purchase price misalignment. There are a lot of ways to address this. One is an earn-out. Most searchers dismiss this since the SBA doesn’t allow earn-outs, but you can still get a commercial loan. Another is a clawback, which may be a solution if you're looking for an SBA loan. In addition, it may help mitigate risk and/or solve issues that arise in due diligence.

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EARNOUT:


1 // What is an earn-out? An earn-out provision is where a portion of the purchase price is payable to the seller dependent on whether certain milestones are reached. There may be tranches of milestones that may trigger certain payouts or equations to determine additional payouts. It is generally tied to performance, but may also be used for other milestones important to the value of the business.


2 // What are the benefits of an earn-out? Allocating a purchase price as an earn-out can allow a buyer to feel more comfortable increasing the purchase price of the transaction because a portion of it is dependent on performance or such other milestone, which is one of a buyer's primary concerns post closing. This may allow them to be more competitive in bids against other buyers with greater access to capital and/or those who generally pay higher multiples in transactions. In addition, if a buyer plans to have the seller be involved post-closing, this can help align incentives (although there are many ways to accomplish this). Overall, it can help close a purchase price gap in negotiations, help an offer stand out, provide upside potential for the seller and align interests post-closing, among other things.


3 // Why doesn't everyone use an earn-out? A few of the biggest reasons why an earn-out may not be a good fit for a deal is (i) if the buyer is only interested in an SBA loan and not commercial loan or other source(s) of funding, (ii) if there is a lot of interest in the target company and there is a competitive bidding process - it may help make a less competitive bid more competitive by allowing the buyer to offer a higher potential purchase price, but with everything else being equal, a buyer will generally select a purchase price paid in full over a purchase price where a portion of it is at risk of being earned, (iii) a seller may not want to risk a portion of the purchase price not being earned even if it may result in a higher total purchase price - it depends on the involvement of the seller post closing, their influence on whether the milestones may be met, their risk tolerance, payout preferences and liquidity needs, and (iv) it may be too complex or difficult to negotiate for the size or needs of the transaction - it's a risk-benefit analysis.


4 // What might be included in an earn-out provision?  An earn-out provision is highly negotiated and complex. It is customized to the transaction at hand, but generally includes the amount of the potential earn-out with tranches of earnings based on certain milestones being met or a calculation to determine the amount of the earn-out, the term of the earn-out, potentially a maximum earn-out that may be earned, how often earn-out payments are determined and made to the seller, details regarding the milestones and triggers, whether the buyer may set off liabilities of the seller against earn-out amounts to be paid by the buyer to the seller, etc.


5 // At what phase of the transaction should an earn-out provision be discussed by the parties? Generally, the earn-out is negotiated in the LOI phase of the transactions with details regarding the parameters of the earn-out provision so that it doesn't become a roadblock in negotiating a purchase agreement. If something comes up during due diligence or negotiations where value is being negotiated, it may come up in purchase agreement negotiations as a solution to keep the deal moving forward. Given the complexity of earn-out provisions, I recommend working with an attorney to draft an LOI that includes an earn-out provision.


CLAWBACK:


1 // What is a clawback provision? A clawback provision is where a certain portion of the purchase price may be “clawed back” (i.e. paid to the buyer) in the event of certain triggers. The amount that may be "clawed back" may be held in part or in full in escrow. Typically, only a portion of the total amount that may be "clawed back" is held in escrow.


2 // What is the difference between a clawback and an earn-out?  Clawbacks are where a buyer pays the total purchase price, a portion of which may be clawback escrow or "clawed back", upfront but may be returned a portion of the purchase price (including and/or beyond the clawback escrow) if certain negative event occur. This is almost the opposite of earn outs which are where a buyer may pay more in the future if certain milestones are met. Essentially, a clawback may allow the buyer to receive a portion of the purchase price back in the event of certain triggers whereas an earn-out may require the buyer to pay the seller more in the event certain milestones are met.


3 // Why would I use a clawback instead of, or in addition to, an earn-out?  If you have a purchase price negotiation gap & an earn-out isn’t a solution because you want to pursue SBA lending, a clawback may be the solution. As with earn-outs, they’re complex and you’ll need a lawyer, but it’s worth it in the long run. If you aren't pursuing SBA lending, they may be used in addition to an earn-out - certain things may trigger an earn-out, such as performance, whereas others may trigger a clawback, such as breach of contract.


4 // What might be included as triggers in a clawback provision?  Clawback triggers may be (i) performance, (ii) key customer, key supplier or key employee loss, (iii) seller’s breach of reps and warranties, (iv) indemnification, (v) etc. You can get creative here to address concerns in the business. This is one way that lawyers can really help you to structure a deal to mitigate risks found in due diligence. For instance, if there's an environmental concern, a certain portion of the purchase price may be held in a clawback escrow account to fund any indemnification that the seller may need to provide the buyer under the purchase agreement to mitigate that risk.


5 // Are there any other parameters to the clawback provision?  Clawback provisions are highly negotiated, complex and specific to the deal. They usually include a cap of what portion of the purchase price may be "clawed back", an expiration of the clawback rights of the buyer, detailed specifics regarding the triggers, provisions prohibiting "double dipping" where the buyer may receive duplicated compensation, etc. It should be included in the LOI phase to address known risks - i.e. the cyclical nature of the business, key man employee risk, client or supplier concentration, etc. It may be included in the purchase agreement to address material issues found in due diligence, but it will be hard to negotiate at that point and the seller may only agree if it's needed to keep the deal moving forward.


This is just one of numerous examples of how having a lawyer on your deal team can help you make a deal work for both parties, save the deal and get a deal to closing. A good lawyer uses their experience to create solutions and solve problems. It may be an initial investment, but it can create a deal that otherwise wouldn’t exist, or save a deal before it goes off the rails. Most M&A professionals get lawyers involved at the LOI phase to help structure the deal to create an environment for success.


Comment below if you’ve used clawback and/or earn-out provisions in your deals and how they’ve worked for you. I’m currently drafting an LOI for a client with clawback provisions and set off provisions. If you'd like to learn more, you can check out my online course, Acquisition Insights: Legal Roadmap for Success, an online course designed specifically to support buyers in their pursuit of acquiring a business with confidence. In addition, we’ve created a complimentary Letter of Intent Masterclass & Checklist. Let me know in the comments below if you'd like access to the LOI Masterclass & Checklist and feel free to let me know if you have any questions! I'd be happy to provide a complimentary consultation if there are deal specific questions you have. Hope you have a great week!

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