Insight

Trading through an earn-out period during COVID-19

COVID-19 has cast uncertainty around the value of an earn-out where the business’ financial performance is being impacted by current abnormal trading conditions, either adversely or favourably.

Sale and purchase agreements may contain earn-out clauses. Such clauses can be a mechanism to bridge the gap between the sale price that the vendor is seeking and the price that the buyer is willing to pay at the date of the transaction with both Parties bearing the risk of the business performance for a specified period of time post-acquisition.

An earn-out may be structured in the sale agreement in a variety of ways and may be based on earning levels or net income. If the intention is for the vendor to continue in the business, the earn-out mechanism keeps them aligned to maximising the business’ financial performance and consequently the earn-out is payable by the purchaser. The sales agreement may have specific clauses in relation to the removal of abnormal or one-off revenue adjustments or costs incurred, however sales agreements entered into prior to COVID-19 are unlikely to contain specific clauses to take account of the effect of such a pandemic,

For the small number of businesses that are being positively impacted by the COVID-19 such as manufacturers and distributors of products in high demand (including medical equipment, medicines, hand sanitisers, personal protection equipment, home paper products, pantry staples, pet food and computer equipment), the impact could result in the earn-out to be more easily achieved as sale are bought forward due to panic buying or an increase in demand for a particular product. This leads to an artificial increase in the total purchase price.

Of course for the majority of businesses whose performance has been adversely affected by COVID-19, the unexpected impact on financial performance will see the transaction risk is borne by the seller and manifesting in a reduced earn-out payment and the lower overall price paid for the business. This may lead to the seller becoming demotivated to act in the best interests of the business and buyer.

An option available to Parties now to minimise the risk of a dispute later would be to renegotiate the sale agreement.

Options include:

  • Continuing with the current earn-out periods but normalise performance to remove the abnormal results triggered by COVID-19, whether they are adverse or advantageous.
  • Renegotiate the target levels.
  • Extend the-earn out period and exclude the months of trading directly affected, to so that the period intended in the contract is still utilised in the earn-out the assessment.
  • If the earn-out period was close to completion, consider reducing the earn-out period to reflect “normal” trading performance under the management of the buyer.

Some issues to consider when looking to negotiate an amended earn-out clause could include:

  • Does the sales agreement allow for such events and include triggers which activate the recognition of an event, for example, changes in the ASX.
  • Can the impact of the COVID-19 on the businesses performance be easily identified? Have sufficient accounting records been kept to allow the impact to be quantified?
  • How will the Parties agree upon the timeframe that normalisations are to be applied or the duration of extensions of time for the calculation of the earn-out given the uncertainty of when the pandemic will pass?
  • Can the Parties reliably estimate the time period that the business will need to return to its pre-COVID-19 performance?
  • Could COVID-19 impact the ability of the business to continue as a going concern and how has this issue been addressed in the sale agreement?
  • Has the effect of COVID-19 on the business impacted on the ability of the buyer to make good on earn-out payments? Can the repayment period be renegotiated if this is the case?

Consider the impact of any amendments to the earn-out clause on related parties. For instance, if the business is sold but the vendor retains ownership of the business premises, how does the lease agreement impact the earnings assessment.

 

In the event that the earn-out clause cannot or is not renegotiated, it is likely that we will see an increase in post-acquisition litigation arising from businesses subject to earn outs that incorporate the COVID19 period. Where a contract is silent or ambiguous on the impact of natural disasters/pandemics/epidemics, Parties may seek the services of an expert to provide an independent assessment of the reasonable quantum of the earn-out under a contract of sale. It will be important for instructions to contain the assumptions upon which the calculation is to be based and may very well include the different scenarios of encompassing the issues that are detailed above.

There are a number of key elements that will need to be considered by the expert including:

  • The duration of the impact of COVID-19 on the subject business. This may be determined by analysis of management accounts if they are produced on a relatively frequent basis by management. In some cases, this may require data to be available on a weekly basis given the pace of change witnessed in the past month.
  • Correspondence between suppliers and management to determine the flow-on effect to the business of supply issues and the duration of the impact to the business operations.
  • Where COVID-19 period income or net profits are normalised then the impact on
    • revenue and whether the change is the result of COVID-19 or other factors that were impacting the business prior to the onset of COVID-19;
    • costs and the extent of any savings to the business due to changes in the manner in which the business operated. For example, where bricks and mortar stores have been closed, what were the cost savings in not maintaining a store presence such as reduced electricity costs, cleaning costs and staffing;
    • the impact of government stimulus packages on the business costs including the JobKeeper scheme, negotiated changes to their banking facilities, re-negotiated commercial lease arrangements and deferral of tax obligations.
  • Analysing the performance of the business in comparison to its competitors and the industry to identify any anomalies to their actual performance during COVID-19 and in the recovery period after COVID-19.
  • If a business is unable to trade through the COVID-19 period we may be instructed to determine the period of performance that was considered unaffected and determine the value of any earn-out payable for that time. A consideration prior to undertaking this assessment would be whether the buyer had the capacity to pay an earn-out. Alternatively, look to the sales agreement to determine if the earn out clauses may be triggered in the event of insolvency.

 

It is imperative that businesses maintain detailed financial records and document the actions and mechanisms relied upon to mitigate against reduced performance during this time. The more information retained during the period of disruption the more reliable the assessment of the potential earn-out will be.

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