Earn-outs and reverse earn-outs | Deal Law Wire

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In May, we wrote about the increased focus on earn-out provisions during the pandemic as a method to mitigate the risk of a target’s post-closing under-performance and to bridge any valuation gap between the purchaser and seller. More recently, we discussed post-closing balance sheet adjustments as a separate tool to address the same risk. In this article, we will focus on (i) reverse earn-out provisions and (ii) a review of the use of earn-outs in 2020 M&A deals.

Earn-out vs. Reverse Earn-out

As described in more detail in our May post, a ‘classic earn-out’ refers to a post-closing increase in the purchase price based on the achieving of certain performance targets, while a ‘reverse earn-out’ refers to a decrease in the purchase price if the performance targets are not achieved. For greater clarity, in a reverse earn-out scenario, the purchaser pays the maximum amount for the target at closing and if the agreed upon performance targets are not met, the vendor must re-pay an agreed portion of the purchase price, reducing the overall price of the target. Reverse earn-outs are used less often because the risk resides with the buyer, rather than the seller.

So why would a party opt for a reverse earn-out rather than a typical earn-out? Provided that there is a reasonable expectation that the performance targets would be met, sellers may prefer reverse earn-outs over earn-outs. Unlike earn-out payments that may be taxed as income (unless the specific conditions provided by the Canada Revenue Agency in IT-426R are met), reverse earn-outs are taxable as capital gains in the taxation year in which the closing occurs, with any amount later determined not to be payable resulting in a capital loss for the seller for the taxation year in which the balance becomes no longer payable. Thus, while the seller must bear the total tax liability at the time of the sale, a reverse earn-out may still be preferable because it minimizes income treatment and maximizes capital gains treatment of the earn-out payment, as described in more detail in one of our blog posts.

One item in particular to consider regarding reverse earn-outs is timing. Because capital losses are limited to a three year carry back to offset a capital gain, the timing for the target to meet performance thresholds should be limited to this period if the seller intends to offset the original purchase price. In most cases, this time limit should not present an issue as three years is at the high end of the average earn-out period, as discussed in the 2018 Canadian Private Target Mergers and Acquisition Deal Points Study.

Earn-out Use in 2020

Given the uncertainty created by the pandemic, many have anticipated that earn-outs would be relied upon more heavily to address the risk of over – or under – valuing a business. In addition, it was predicted that earn-out timeframes would be extended to account for the extended uncertainty created by the pandemic. In our survey of private acquisition agreements available on Practical Law – What’s Market, we found that the predicted reliance on earn-out clauses in 2020 was not significantly higher than 2019. In Canada, the use of earn-out clauses decreased from 28% of surveyed deals in 2019 to 24% in 2020. The average use of earn-out clauses in Canadian and U.S. deals, combined, stayed consistent at 19%, suggesting that, while Canadian usage of earn-out clauses may have decreased, use in the U.S. increased. Our review of past Canadian and U.S. private M&A deal points studies demonstrates that U.S. M&A transactions are more likely to include earn-out provisions as compared with Canadian transactions, as discussed here. Further, we found that of the 2020 Canadian deals surveyed that included earn-out provisions, only 7.5% (or 2 out of 15) used reverse earn-outs. This data point underlines the limited use of reverse earn-out provisions, even in the context of highly uncertain times.

Conclusion

While the pandemic is not over yet, parties are becoming more comfortable with the uncertainty created by it. As a result, deal flow is steady and we expect to see a further uptick in M&A activity as the year progresses. We expect that the use of earn-outs will continue more or less at its current pace as parties make context-dependent decisions about how best to allocate deal risk without significantly increasing the risk of disputes.

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