It is common for merger and acquisition (M&A) agreements made between private companies to feature earnouts. Earnouts coordinate deferred payments from a buyer to the seller’s shareholders based on the acquired business’ performance. These contractual obligations identify and allocate risk when the purchase price of a company is set as the base value and additional payments – earnouts – are made depending on whether the company meets defined performance benchmarks during a set period of time.

Earnouts can be an effective solution in transactions where the buyer and seller cannot come to terms on the upfront price of a company.

Bridging the Valuation Gap

Disagreements between buyers and sellers about a company’s valuation aren’t new. Sellers, of course, want to get the highest price possible and often believe their business is worth more than it really is. Acquirers, meanwhile, might be wary about the seller’s growth projections and the ability to retain major clients and key employees.

An earnout can help bridge their views on the business’ valuation. For example, if a seller thinks his business is worth $100 million and a buyer thinks it’s worth $80 million, they could agree on an upfront purchase price of $80 million and make the $20 million difference part of an earnout.

Earnouts can be useful if a target company is a startup with little operating history but significant growth potential. They may also be beneficial in a rising interest rate environment as acquirers may want to make delayed payments or pay with capital generated in due course from business operations. Earnouts might also be a good option if the acquirer wants to incentivize management to stick around for two or three years to help with the transition.

For acquirers, earnouts reduce the risk of overpaying for a business because the total price is based on the company’s actual, not projected, performance. For sellers, they are essentially a form of seller financing, adding uncertainty to the transaction. However, earnouts could expand the potential universe of acquirers and help nudge a reluctant buyer over the finish line.

Structuring the Earnout

The structure of an earnout is critical for both sellers and acquirers. Here are a few key issues related to earnout structure:

Performance metrics: Which metrics will be used to determine whether the business has met the performance milestones specified in the earnout? Common financial metrics for earnouts include EBITDA, gross revenue, net income, and earnings per share.

Acquirers prefer EBITDA because it is the most reliable indicator of value and profitability. However, sellers sometimes resist EBITDA because they believe it can be manipulated by buyers to lower the earnout. Sellers prefer that gross revenue or gross profits be used as a performance metric. Non-financial metrics can also be used as performance milestones. In bio-pharma acquisitions, for example, milestones might be tied to the success of clinical trials or obtaining FDA approval.

Earnout period and payout structure: Over what period must performance milestones be met, and how will the payout be structured? This could be gross revenue during the current year, EBITDA for the next three years, or cumulative EBITDA after three years. Earnout periods are typically between one and three years.

Also, must an absolute milestone be met before any payouts are earned, or can a percentage of the payout be earned upon partial satisfaction of a benchmark? For example, the payout could be structured with gradated payouts for gross revenue during the year between a range of $80 million and $100 million. If a minimum payout is required in the future, this is placed in an escrow account.

Appropriate accounting standard: The buyer and seller must agree on which accounting standard will be used to determine whether the financial metrics have been achieved. This could be the seller’s accounting standard before the acquisition or the buyer’s accounting standard. A reference to GAAP in and of itself is usually not sufficient.

Specific accounting matters to be considered for the earnout include the use of cash or accrual accounting, revenue and expense allocation, the timing of revenue recognition, the treatment of acquisition expenses and other non-recurring items, and the treatment of uncollected receivables.

Post-closing business operation: There are two main questions. First, how will control of the business be allocated between buyer and seller after the acquisition? And second, what level of support—if any—will the seller be obligated to provide to the business?

Sellers sometimes want to retain a level of control over business operations, such as approval rights over major decisions. At a minimum, sellers should require restrictive covenants that set limits on operations to prevent the acquirer from making significant changes that reduce the earnout, such as discontinuing products or shrinking the sales force.

The seller could require the buyer to operate the business similar to how it was operated before the acquisition. For their part, acquirers should try to include language in the agreement that gives them absolute discretion over operations and negates any obligation toward supporting the business or achieving the earnout.

Earnout Disputes and Resolutions

Earnouts can sometimes lead to disputes between sellers and acquirers regarding whether the payout was actually earned or the acquirer manipulated the earnout to lower it. To minimize disputes, the purchase agreement should clearly articulate the buyer’s obligations to prepare and present financial statements and earnout calculations and the seller’s right to challenge them. Arbitration procedures should be established in advance and included in the acquisition agreement to resolve any potential disputes like these, with an independent accountant or auditor serving as the arbitrator.

Protect Your Interests

Earnouts are useful tools for ensuring M&A agreements make it to completion. Buyers and sellers should pay close attention to how an earnout is arranged to make sure their interests are accounted for.

Contact Dembo Jones to explore how earnouts can apply to your M&A agreements.