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How much of an earn-out can the buyer's accounting adjustments remove?

The metric an earn-out pays on is a number the buyer controls after completion, and the clauses that fix it cost far less than the money they protect.

Julian R. Sterling · from Closing the Deal

Six ordinary post-completion adjustments, worth €1.30 million a year of EBITDA between them, remove €6.60 million of a €12.0 million earn-out. The business earned €16.90 million and €17.40 million of EBITDA against a €16.0 million threshold and an €18.0 million target. With the protection clauses in the agreement the earn-out pays €6.90 million. Without them it pays €0.30 million. Not one of the six adjustments is improper, and none of them is made in bad faith.

The six adjustments

Meridian Components is sold on an enterprise value of €118.0 million — 8.0 times €14.75 million of EBITDA — with an earn-out of up to €12.0 million over 2 years on top. The earn-out pays nothing below €16.0 million of EBITDA, pays in full at €18.0 million, runs on a straight line between the two and is capped at €6.0 million a year. As a share of enterprise value it is 10 per cent.

After completion the buyer does six ordinary things. None of them is improper and none of them is done to defeat the earn-out.

Six post-completion actions on the Meridian earn-out.

Buyer action	Note	Effect on EBITDA (EUR m)
Buyer’s management charge	Allocated head office cost the target never bore	−0.75
Change of accounting policy	Capitalisation threshold, revenue recognition	−0.35
Integration and restructuring costs	Incurred to realise the buyer’s synergies	−0.60
Synergy benefit credited	Procurement savings the buyer delivered	+0.45
Bonus accrual for the retained team	New scheme, imposed after completion	−0.30
Capex deferred by the buyer	Maintenance postponed; flatters the year	+0.25
Net effect on each year’s EBITDA		−1.30

What that does to the money

The business earned €16.90 million and €17.40 million. Both years clear the threshold comfortably, and on the reported numbers the earn-out pays €2.70 million and then €4.20 million. After the buyer’s adjustments the first year falls below the threshold entirely and the second barely crosses it.

The same trading performance, priced with and without the protection clauses.

Basis	Year 1 (EUR m)	Year 2 (EUR m)	Total (EUR m)
EBITDA as reported by the business	16.90	17.40
EBITDA after the buyer’s adjustments	15.60	16.10
Earn-out with the protections	2.70	4.20	6.90
Earn-out without the protections	0.00	0.30	0.30
Difference			6.60

€1.30 million a year of accounting entries removes €6.60 million of a €12.0 million earn-out. The seller receives €0.30 million instead of €6.90 million, on a business that beat its threshold in both years.

The leverage is in the arithmetic of the straight line, not in the size of the adjustment. Between a €16.0 million threshold and an €18.0 million target, €6.0 million of consideration is spread over €2.0 million of EBITDA: every euro of EBITDA is worth three euros of price. A charge the buyer would not think twice about in the ordinary running of a subsidiary is multiplied by three before it reaches the seller.

The protections, in order of value

• No charge from the buyer or its group that the target did not bear before completion. The single most valuable line — €0.75 million a year on the management charge alone — and the easiest to obtain, because a buyer that refuses it is saying something.
• Accounting policies frozen at those applied immediately before completion, with any later change disregarded for the earn-out calculation.
• Integration and restructuring costs excluded, together with any cost incurred to realise a synergy — and, symmetrically, any synergy benefit excluded too. The symmetry is what makes it acceptable to a buyer, and it is what a seller should offer rather than wait to be asked.
• A conduct covenant: the business is run in the ordinary course, consistently with past practice, and no action is taken with the purpose of reducing the earn-out. Weaker than it sounds, because purpose is hard to prove, but it is the clause an expert will read.
• Information rights: management accounts delivered quarterly in the same format as before completion, and access to test the final calculation. Without these the seller cannot even detect a problem.
• A worked example of the calculation on the last completed year, attached to the agreement and expressed to be determinative.

A buyer that has just paid €61.17 million for the shares is entitled to run the business, and a seller who asks for protections amounting to a veto will not get them. The trade that works is complete operational freedom and a shorter earn-out period for the buyer, against the six clauses above for the seller, plus an acceleration: a stated amount payable if the buyer sells the business, restructures it, or takes an action the covenant would otherwise prohibit. That converts every future argument into a price the buyer can choose to pay.

What to do with this

Price the clauses before conceding them. The six protections cost the buyer nothing in cash and are worth €6.60 million here, which is more than half the earn-out and more than a full turn of multiple on €14.75 million of EBITDA. They belong in the letter of intent, not in the third mark-up of the purchase agreement: once exclusivity has been granted the leverage has gone.

Then compute the band. The first euro is payable at €16.0 million and the maximum is reached at €18.0 million — a 12 per cent band on a business whose EBITDA moved from €14.75 million to €16.90 million in the last year. A band narrower than the business’s own volatility is not an incentive; it is a coin toss. And ask the threshold question first: who controls the thing the payment depends on? If the answer is the buyer, an earn-out on profit is a payment the buyer decides, and a metric outside the buyer’s control — revenue, or an operational milestone — is worth more than any set of protections written around EBITDA.

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