Company Mergers: Understanding the Role of Earn-Out Clauses and Asset Liability Guarantees
A company merger can take various forms, including the acquisition of another company's equity capital or the purchase of its net assets (assets and liabilities). This operation can be carried out through the issuance of shares (or share exchange) or by transferring cash, cash equivalents, or other assets. This article focuses on transactions involving cash payments for the acquisition of equity capital, the most common and straightforward approach.
The Benefits of a Clean Break
When a seller transfers all their shares in an entity, they no longer have any proprietary exposure to the company and retain no residual links with the buyer after the transaction, unless the sale agreement includes an asset and liability guarantee clause or provides for an earn-out, also known as a price supplement.
The Importance of Asset and Liability Guarantees
An asset and liability guarantee clause is highly recommended to protect the buyer when acquiring a target company. This clause ensures the accuracy and consistency of the assets (e.g., property, inventory, customers) and liabilities transferred to the buyer as of the property transfer date, and shields them from potential latent liabilities. The contract stipulates that the seller will indemnify the target company and/or its creditors in the event of an increase in liabilities or decrease in assets resulting from pre-transfer events.
The Role of Earn-Out Clauses
An earn-out clause, on the other hand, is included in the share sale agreement to adjust the purchase price. Typically, it involves a price supplement indexed to the target company's future performance (e.g., EBIT, net income). While it can be beneficial for adjusting the sale price, this clause presents several drawbacks, including:
- Uncertainty regarding the final price
- Potential disputes between the seller and buyer over the measurement and interpretation of performance
- The risk of financial result manipulation
- The complexity of its application, which may require additional resources to evaluate performance
By understanding the role of earn-out clauses and asset liability guarantees, companies can better navigate the complexities of mergers and acquisitions, ensuring a smoother and more secure transaction process.
