Whilst it might not jump out at you as being the trendiest of topics, leavers and earn-out provisions can be crucial components in share or asset purchase agreements.
What are earn-out provisions?
An earn-out provision is a contractual arrangement where some (or, less commonly, all) of the purchase price is determined by the future performance of the target company over a specified period of time. An earn-out provision is therefore a form of deferred consideration. Where a seller will continue to work within the target business post-acquisition, an earn-out provision operates as an incentive for the seller to stay on and ensure that the business continues to thrive post-acquisition.
If the seller were to leave the company during this period, they’re known as Leavers. A leaver can either be classed as a “good leaver” or a “bad leader” depending on the circumstances of their departure.
Understanding the details of earn-out and leaver provisions are essential for exiting shareholders as well as buyers as they can impact the financial outcome and stability of the deal as well as the ongoing success of the newly acquired target company.
How do earn-out provisions work?
Earn-out provisions are commonly utilised within sale and purchase agreements.
The payment of an earn-out often varies and is based on meeting certain events which are usually linked to the financial targets or some other performance metric of the target company over a specified period (or periods) of time. Typically, the buyer will make a payment to the seller on completion followed by a further payment or series of payments depending on if these events are met.
An earn-out can often be a useful tool to bridge the difference in expectations of buyer and seller regarding the value (and future performance) of a target company to help facilitate a transaction, rather than the transaction collapsing if there is a disparity in views on value between the buyer and seller.
Good leaver vs bad leaver: how are they defined during an earn-out period?
“Good leaver” and “bad leaver” terms play a pivotal role in mergers and acquisitions particularly when an earn-out forms part of the deal structure. The negotiations of these definitions will be a fundamental part of the transaction as they could ultimately determine the financial outcome for an exiting shareholder.
A “good leaver” is typically an individual who exits a company under circumstances that are deemed favourable or acceptable by the terms of the acquisition agreement, typically reasons the individual is unable to control. These circumstances often include death, incapacity or disability, retirement, redundancy, unjustifiable dismissal or other pre-approved reasons.
Conversely, a “bad leaver” is someone who departs the company under circumstances that are unfavourable or detrimental to the buyer, typically for reasons within their control and which have been pre-agreed as deeming them to be a “bad leaver”. This might include individuals who voluntarily resigns within the earn-out period, engage in competition with the buyer or are dismissed for cause, such as gross misconduct.
When negotiating a sale agreement, a buyer and seller should carefully consider all the circumstances in which a seller could leave their employment with the target company and agree how this will impact the earn-out.
What are the financial implications for good leavers during an earn-out period?
This will depend on the drafting of the sale and purchase agreement, however, the financial implications for “good leavers” during an earn-out period are usually intended to be positive and are designed not to penalise individuals who exit a company as a “good leaver” (as defined in the acquisition agreement). “Good leavers” are typically entitled to continue to participate in the earn-out consideration and have the opportunity to receive the financial portion that they are entitled once the earn-out period concludes, as if they had continued to be employed in the business.
What penalties do bad leavers face during an earn-out period?
“Bad leavers” typically face several penalties. The specific penalties will depend on the terms outlined in the agreement but one of the most significant penalties for bad leavers is that they may lose their entitlement to earn-out payments, meaning they would be excluded from receiving any share of the deferred consideration linked to that earn-out period. Alternatively, bad leavers could receive a reduced earn-out payment based on the terms specified in the agreement.
The penalties imposed on bad leavers are designed to discourage actions that could harm the acquired company’s success and value during the earn-out period and so it is important to know what circumstances of departure would deem a seller being a “bad leaver” when negotiating the sale agreement.
Are there any other financial implications such as tax?
Any linkage between earn-out payments and a seller’s continued employment in the target business will need to be considered very carefully from a tax perspective, as there are risks associated with this.
This will most certainly impact the negotiations between buyer and seller on leaver provisions where there is earn-out consideration involved and it will be important for the parties to take appropriate tax advice.
How Moore Barlow can help
Earn-out and leaver provisions are intricate mechanisms in merger and acquisition agreements, crucial for aligning the interests of exiting shareholders with the buyer’s new business aspirations and expectations following acquisition. Careful definitions and consideration of these provisions ensure financial fairness and stability, making them vital tools for a successful post-acquisition period.
It’s important to note that the specific financial implications for “good leavers” and “bad leavers” will vary based on the terms and conditions outlined in the acquisition agreement and time should be taken to carefully review the terms of the contract to ensure the parties are aware of what a seller is entitled to if they leave the target business post-sale, during the earn-out period.
Our corporate solicitors have a wealth of experience in corporate matters and regularly advise on earn-out and leaver provisions in sale agreements as well as facilitating the appropriate tax advice. For more information about how our solicitors can help you, contact the Moore Barlow corporate team today.