Purchase price adjustments in M&A: how completion accounts and earn-outs work

What are completion accounts, and how do earn-outs work? Both are purchase price adjustments: mechanisms in a share purchase agreement that move the price up or down after completion based on what the business actually turns out to be worth. Completion accounts adjust for the position on the day of completion. Earn-outs adjust for how the business performs over a period afterwards. Each needs specific drafting in the SPA to avoid a dispute later.

Types of purchase price adjustment

There are two main types of adjustment to the purchase price in M&A deals:

• Completion accounts, which compare the actual financial position of the business at completion with the position the price was based on.
• Earn-out provisions, which link part of the price to the profit the business generates over an agreed period after completion.

They solve different problems. Completion accounts protect against the business being in a different state on completion day than the parties assumed. Earn-outs bridge a gap between what the seller says the business will do and what the buyer is prepared to pay for today.

What are completion accounts?

Completion accounts are the financial accounts of the target business as at the date of completion. Their aim is to establish the value of the target business at the point of completion.

Why does that matter? The buyer and seller will have negotiated a purchase price, and the SPA may specify that price alongside target assets and target liabilities for the business. The completion accounts then look at the actual assets and actual liabilities on the completion date and compare them to those targets:

• If the actual assets are more than the target assets, the purchase price is increased. If they are less, it is decreased.
• If the actual liabilities are greater than the target liabilities, the purchase price is decreased. If they are lower, it is increased.

Typically these adjustments are made by increasing or decreasing the deferred consideration, the part of the price still outstanding from the buyer to the seller after completion. That is simpler than the seller having to hand money back or the buyer having to find more cash at short notice, and it is one reason buyers like to keep part of the price deferred rather than paying everything on the day.

How does an earn-out work?

With an earn-out, the buyer and seller negotiate two main numbers:

• The purchase price.
• The target profit to be generated over a number of years. That period is called the earn-out period.

If, during the earn-out period, the business makes more profit than the target profit, that excess profit is typically given to the sellers. In other words, the purchase price goes up by increasing the deferred payment. The opposite is also true: if the actual profit over the earn-out period is below the target profit, the purchase price goes down by decreasing the deferred payments.

The adjustment can be done pound for pound, so that each pound of profit above or below the target moves the price by a pound, or on whatever other metric the parties decide to agree. The commercial logic is that the seller is paid for the performance they promised only if that performance actually materialises, while the buyer avoids paying up front for profits that may never arrive.

Completion accounts schedule in the SPA

What should you include in the SPA to avoid, or at least minimise, legal disputes? For completion accounts, the answer is a schedule that details exactly who is to prepare the completion accounts and how they are to be prepared.

The reason is that completion accounts are only useful if both sides accept the numbers. Who draws them up, what accounting policies apply and how disagreements are resolved all need to be settled in advance. Leave any of that open and the adjustment that was supposed to be mechanical becomes a negotiation, or a dispute, after the deal has already closed.

Earn-out restrictions to include in the SPA

For an earn-out, the issue is different. The sellers are usually still managing the business during the earn-out period, and their reward depends on the profit it makes in that window. So you may want to include provisions in the SPA that tell the sellers what they are and are not allowed to do while the earn-out runs.

The reason is simple. During the earn-out period, sellers are more likely to prioritise squeezing out as much profit as possible rather than pursuing longer-term gains. They will not be around to benefit from the long-term gains, but if they maximise profit now they adjust the sale price in their own favour. Cutting investment, delaying spending or pushing customers for short-term revenue can all flatter the earn-out figures at the expense of the business you will be left with. Operating restrictions in the SPA are how a buyer guards against that. The restrictions need to be specific enough to be enforceable, which is another reason the earn-out provisions deserve careful drafting rather than a single line in the SPA.

Why the drafting matters

Whether you are the buyer or the seller, and whether you are using completion accounts or an earn-out, these mechanisms determine how much money actually changes hands. In my experience, the deals that end up in dispute are rarely the ones where the parties disagreed about the headline price. They are the ones where the adjustment mechanism was vague. A close working relationship with your M&A lawyer while the SPA is being drafted is the best protection against that, because the lawyer needs to understand the commercial deal in order to write a mechanism that reflects it.

Next steps

If your deal involves completion accounts, make sure the SPA contains a full schedule covering who prepares them and on what basis. If it involves an earn-out, make sure the target, the period, the metric and the operating restrictions are all set out clearly. Speak to a corporate solicitor with M&A experience before the price mechanism is agreed in the heads of terms, because it is far easier to get right at the start than to fix after completion.