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Addressing Future Uncertainty: Vesting and Earn-Out Provisions

Both vesting and earn out provisions are important tools used by investors to mitigate some aspects of future business uncertainty, especially in relation to growth-oriented valuations. This article discusses how these two tools are relied on by investors to this effect, and how the companies or management may better negotiate such provisions towards a successful transaction.

Vesting Provisions

A vesting provision delays the earning of the full entitlements of shares or stock to founders or management of a company to be pursuant to an agreed vesting schedule, usually over three or four years. If the individual subject to vesting leaves the company before the vesting period is complete, the company has the right to cancel or buy back the unvested shares at the lower of cost or fair market value.

Vesting provision are often used for shares issued to a founder of a company and for ESOP shares, options, or participation rights. Because founders and senior managers receive compensation made up of both cash and equity, subjecting the equity to vesting essentially conditions part of the compensation on the continuity of service during the vesting period, thus decreasing the likelihood that the person would voluntarily leave and therefor increase the business risks, and also tying the fortunes of the employee to the those of the company he/she is serving. The leave risk is particularly acute in startups, where the product or service is significantly less valuable than the management team. Additionally, if the founder does choose to leave, the cancelled or returned shares give the company firepower to recruit and incentivize a replacement without diluting as much value from the remaining shareholders.

The most common vesting period is 36-48 months. The vesting shares gradually vest over the vesting period, often monthly or quarterly. Once vested, the shares are fully owned by the founder with no risk of loss. The provision might also include a “cliff,” meaning that the initial vesting interval is longer, with more regular vesting occurring only after the cliff has passed. Customarily a cliff of 1 year is imposed on vesting shares.

One of the most contentious parts of a founder departure is whether they a “good leaver” or “bad leaver.” Any time a founder leaves for cause, they are clearly a bad leaver. A founder is a good leaver if they are asked to leave under positive circumstances, such as when the business has reached a certain level of maturity and the founder is no longer the right profile fit for the company’s needs. Good leaver and bad leaver provisions customarily impose additional or less vesting on to the standard vesting structure. Where it gets most complicated is when the founder chooses to leave. Many believe that this is automatically a bad leaver scenario, while others argue that there is not a one size fits all scenario. For example, the founder may be suffering from illness forcing his/er departure.

Earn-Out Provisions

 An earn-out is an agreement between the seller and buyer of a target company where some or all of the selling price is contingent on the future performance of the business. An earn-out is used to shift the risk from the buyer to the seller while still preserving future upside gains for the seller.

An earn-out provision is used in private equity and venture capital as a mechanism for bridging the difference in valuation perspectives regarding the target company. If an earn-out is employed, the seller or company agrees to accept a lower initial valuation for the prospect of benefiting if the business prospers through the incoming investment or purchase.

An earn-out is considered a fair method for addressing a scenario where a company or a seller believes the future value of the company is high, but the investor or buyer has concerns given the current business, economic state, or forecast assumptions. An earn-out allows the company or seller, who know the business better than the incoming buyer, to benefit if the business meets its projections. In cases of venture capital investments, earn outs permit the founders to benefit from achieving their projections where the investment valuation is below such projections.

There are a number of important considerations when including an earn-out provision in a sale or investment:

  • Choose a metric for the earn-out. Targets are normally financial targets, such as revenue, but could also be milestones specific to an industry. This will be a heavily negotiated aspect of the provision because both parties will seek to choose a metric whose data can’t be manipulated. The more objective and straightforward the metric, the more likely the earn-out will be accomplished without dispute.
  • Consider timing. The provision will need to detail the timing of payments and length of the earn-out period. The most common time frame is somewhere between three and five years, but in venture capital investments it can be as short as one or two years. Interim targets are a tool that can be utilized if there is a struggle to reach consensus on the length of the earn-out period. An earn-out will often include interim payments or valuation adjustments on a set schedule assuming targets are met. Most earn-outs will include a cap on the possible valuation and sellers will negotiate a floor.
  • Control over the business. Earn-outs can be cumbersome to buyers and investors if there are restrictions placed on their control of the business. Sellers or companies, on the other hand, face legitimate concerns of not securing their earn-out if the business is mismanaged. Selection of appropriate benchmarks that ensure both the seller/company and buyer/investor win when they are achieved lessen the conflict over control. In instances of sale of control, the parties will need to work through these difficult questions, including whether the target business must be kept separate from the rest of the buyer’s company. The buyer and seller should work together to develop a growth plan and define the investments and actions needed to accomplish the goals.
  • Incentives for key employees. Often the future potential of a business depends on key employees staying in role. If this is the case, consider including incentives for these key employees if performance metrics are met. Also consider coupling earn outs with vesting provisions.
  • Protection against change of control. To safeguard against a scenario where the buyer sells the company during the earn-out period, the seller should negotiate for immediate vest language in the provision. Under such a provision, the deferred payments would immediately vest upon a change in control.

The most important guidepost in drafting an earn-out provision is to strive for clarity. Earn-outs can provide significant benefits to both a buyer/investornd seller/target and ensure that a company continues to perform successfully. If, however, the provision is drafted vaguely, it leaves open significant possibility for disputes between the parties.

If you are dealing with complicated business structuring questions, including around vesting and earn-out provisions, it is important to work with a firm with deep expertise in supporting M&A transactions. Hammad & Al-Mehdar represent over 35 years of experience in providing legal services in Saudi Arabia and the UAE at international standards, and boasts an award winning M&A practice. Contact us today to discuss how we may be able to support the legal demands relating to your M&A transaction.