Back in April 2015, we discussed key questions to keep in mind when negotiating earn-outs, and looked at recent trends coming out of the American Bar Association's 2014 Canadian Private Target M&A Deal Points Study (the 2014 ABA Study). As the ABA has now published its 2016 study (the 2016 ABA Study), we thought it may present a good opportunity to revisit the topic and look at some key earn-out trends.
General use of earn-outs
The 2016 ABA Study showed a decrease of earn-out clauses present in the transactions surveyed down to 17% from the 25% level in the 2014 ABA Study, and the 21% level in the American Bar Association's 2012 Canadian Private Target M&A Deal Points Study.
Performance metrics
One of the most important steps in structuring an earn-out is determining and clearly defining the performance metrics to be used. Based on the 2016 ABA Study, it seems that financial metrics are becoming increasingly popular. Out of the earn-out clauses evaluated, 25% of them used top-line revenue as a metric and 38% used an earnings based metric, while only 19% (down from 53% in 2014) used some other form, which included non-financial metrics. While sellers will typically tend to prefer more clear cut and harder to manipulate metrics such as revenues, and purchasers often prefer an earnings-based metric (having valued the transaction based on earnings), there are some isolated instances (6% in the 2016 ABA Study) where the parties have structured the earn-out using both revenue and earnings metrics.
Time period
Earn-out periods between one and three years have consistently been the most common in terms of Canadian M&A transactions in recent years. The 2016 ABA Study is notable in that there were no transactions that used an earn-out period of four years or longer, compared to 20% in the 2014 ABA Study. It is possible that companies are finding that longer earn-out periods are unnecessarily delaying full integration of the business, or that sellers are unwilling to increase the long-term performance risk they take on, particularly as their impact and influence on the organization's performance would typically be expected to decrease over time.
Acceleration clauses
One trend that is picking up steam is the inclusion of express acceleration provisions in earn out mechanisms, which are triggered upon the occurrence of certain events. As discussed in our previous post, an acceleration of the earn-out can be beneficial to the purchaser or the seller depending on the circumstances. The ability for a purchaser to "buy-out" an earn-out payment can provide for greater flexibility if the future of the company is different than what was predicted. This may be the reason for the sharp increase of earn-out transactions containing an express acceleration clause. While only 7% of transactions contained such a clause in the 2014 ABA Study, the 2016 ABA Study found that 31% of transactions had an express acceleration clause.
While the total number of earn-out clauses present in the transactions surveyed by the ABA decreased from its previous study, they still remain a useful tool to benefit both the purchaser and the seller, and should be carefully considered when completing a transaction.
The author would like to thank Simone Nash, articling student, for her assistance in preparing this legal update.
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