Earn-out mechanism ‘increasingly prevalent’ for mid-market M&A deals in Ireland

An earn-out is a mechanism used in the sale of a company’s shares where part of the purchase price is determined by the post-completion performance of the target. Typically, the earn-out is based on the target’s profits over specific financial periods after completion, but it can also be linked to other benchmarks, such as turnover, net assets, the number of products sold or new customers gained.

This structure has become increasingly prevalent in the Irish market in recent years, especially for mid-market M&A deals, according to legal experts Gerry Beausang and Robert Dever at Pinsent Masons, writing in Irish Tax Review.

“Earn-outs can assist in bridging valuation differences between the buyer and seller, especially where there is a discrepancy between the parties in the perceived value of the target,” said Beausang. “An earn-out mechanism can also be particularly useful where the buyer is more leveraged in the sense that it can allow the buyer to mitigate its risk by linking part of the consideration proceeds to the target achieving specific performance targets post-completion.”

For example, sellers may have more optimistic expectations for the company’s future performance, especially if the company is at an early stage with potential for rapid growth or has an innovative product or technology. Earn-outs can be used to bridge valuation differences and allow buyers with limited budgets to defer part of the purchase price.

Although the mechanism offers a range of advantages to both sides of the deal, the experts said, the underlying issues can lead to complex negotiations and certain disadvantages.

“The parties should be aware that the legal agreement around an earn-out can be costly and difficult to negotiate in practice and, even then, there is always the potential for disputes to arise post-completion,” Beausang said.

One of the ways to avoid post-transaction disputes is for the parties to agree on the benchmarks and the methodology for calculating performance prior to closing the sale. Parties are also advised to document the mechanics for calculating and finalising the earn-out and agree on a procedure for resolving any disputes in the earn-out schedule of the share purchase agreement.

Dever noted that there may be certain instances where an earn-out is not workable or appropriate for a commercial or practical perspective. “This can include cases where the buyer intends to integrate the target with its other businesses after the acquisition. In those cases, fixed deferred payments or performance-based bonuses may represent feasible alternatives to an earn-out mechanism,” he said.

Tax considerations are also critical for earn-outs, as different structures of the same transaction can have different tax implications.

“In weighing up their options, all of the parties should take appropriate advice regarding the tax implications for them of entering into to the earn-out. Both sides should also be aware that seemingly innocuous aspects of the earn-out structure can have dramatic implications from a tax perspective and so care is required to avoid the risk of unintended tax consequences,” said Dever.