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Earn-In Agreement Investopedia: Understanding the Basics

An earn-in agreement, also known as an earn-out agreement, is a contractual arrangement commonly used in mergers and acquisitions (M&A). The agreement typically outlines how the buyer will pay the seller based on the future performance of the acquired company. This type of agreement is often used when the buyer wants to mitigate the risk of overpayment by tying the purchase price to future metrics such as revenue, profits or other performance indicators.

Investopedia defines an earn-in agreement as “a type of option contract that allows an investor to accrue the right to exercise a call option over time” where the ultimate purchase price is dependent on the performance of the underlying asset. This article provides a comprehensive overview of the earn-in agreement and explores how it works.

The Basics of an Earn-In Agreement

An earn-in agreement is an option contract that typically consists of three main components: a premium, a strike price, and a vesting schedule. The premium is the amount paid by the buyer to the seller for the right to acquire the asset at a later date. The strike price is the price at which the buyer can exercise the option. Finally, the vesting schedule specifies the conditions under which the option can be exercised.

Earn-in agreements are commonly used in the mining and natural resources industries. In these industries, exploration companies may enter into earn-in agreements with mining companies, allowing the latter to earn a percentage of ownership in a mineral deposit or resource asset in exchange for investing capital in the exploration phase. The mining company would then use its expertise to determine whether the asset is economically viable and if further investment is warranted.

How an Earn-In Agreement Works

An earn-in agreement usually involves a buyer who seeks to purchase a company or asset from a seller, but is not confident in the asset`s ability to generate future cash flows. Therefore, the buyer will structure the purchase terms in an earn-in agreement. Under the earn-in agreement, the buyer is required to pay a portion of the agreed-upon purchase price upfront, with the remaining balance being paid out over time based on the asset`s future performance.

The buyer may require the seller to meet certain performance targets before the remaining balance can be paid out. For example, if the seller is selling a company, the buyer may require the company to achieve certain revenue or profit targets over a specified period. The agreement may also have clauses for the buyer to potentially acquire further ownership of the asset should it meet certain performance targets in the future.

Benefits of an Earn-In Agreement

Earn-in agreements are beneficial to both buyers and sellers in different ways. For buyers, this type of agreement reduces the risk of overpaying for assets, as the purchase price is based on future performance. This creates a structure for buyer and seller to share the risk of future performance. For sellers, an earn-in agreement provides liquidity upfront and offers the possibility of receiving a higher purchase price if the asset exceeds performance expectations.

Conclusion

The Earn-in agreement is an option contract that is becoming increasingly common in M&A deals. This type of agreement is used to mitigate the risks of overpayment by tying the purchase price to future performance metrics. It benefits both buyers and sellers in different ways, providing liquidity to the seller and mitigating risk for the buyer. As always, it is essential to fully understand the terms of an earn-in agreement before entering into one.