The Value of Earnouts
Earnout structures are a very useful tool in M&A transactions.
They are one of the best ways, if not the best way, to bridge the gap between a seller’s price expectation and what the buyer is willing to pay. Earnouts can also be used to ensure that a seller who is key to the ongoing operation of the target remains engaged in the growth & profitability of the business once it is acquired.
However, all too often earnouts end up in a dispute between the seller and the buyer.
I’ve helped to structure and negotiate numerous deals that included an earnout. I’ve also advised on the painful fall-out from earnouts that have failed to meet the parties’ expectations.
This article explores the benefits of earnouts and provides some practical steps that can (and should!) be employed to reduce the risk of a costly and time-consuming dispute.
Earnouts Explained
In an earnout, the purchase structure includes one or more payments that are contingent on the future performance of the acquired business. Those payments are typically linked to post-close profits, but may also be based on revenue, customer acquisition or similar business metrics. The parties will identify the metrics, and targets for these metrics, in the purchase agreement and set out how and when additional payments would be calculated and paid.
Earnouts are most commonly used when a buyer and the seller cannot agree the value of the target, or where there’s uncertainty about its future financial prospects. They can also be used where the buyer wants to retain & incentivize the seller to work in the business, or where the parties agree that the seller should share in the benefit of post-close growth.
Where they are used, earnouts typically make up 10%-25% of the total purchase price.
The Benefits of Using an Earnout
For buyers, an earnout reduces the amount that they need to pay upfront (obviously this a plus in a high interest rate environment). They also help to reduce the buyer’s risk of over-paying where there is uncertainty about future performance. Lastly, they are an effective way to retain & engage a seller post-close, as the seller has a strong incentive to stay working in the business.
For sellers, the key benefit is financial: they offer the possibility of additional payments (sometimes significant) based on the future performance of the business. They can also ‘unlock’ deals that might not otherwise proceed.
… But, Beware the Risks!
In theory, the buyer’s and the seller’s interests are aligned in using an earnout. All too often, however, earnouts end in a dispute.
The source of dispute is almost always because the earnout payment falls below what the seller expected. Here are the two common scenarios:
- The target business underperforms in the metrics chosen by the parties, and the seller believes that the buyer is wholly or primarily responsible, for example where the seller thinks that the buyer has underinvested in sales & marketing that could have driven revenue growth.
- The seller doesn’t agree with how the buyer calculates the earnout payments, for example where the seller believes that management charges levied by the buyer on the target for centralized accounting, HR or IT support etc are unjustified and should be disregarded for the purpose of calculating a profit-based earnout.
With significant amounts of money at stake, disputes can quickly become acrimonious. An earnout dispute can be damaging for all concerned. Implications include:
- The dispute will likely bring an end to the working relationship between the buyer and seller.
- It can be hard to shield clients from the fallout of the dispute, damaging goodwill.
- The dispute will be a distraction from the ongoing operations of the acquired business and sometimes the buyer’s existing business.
- A dispute can lead to costly arbitration or litigation.
- Disputes consume money and management time, eroding the buyer’s ROI.
The implications of going down this route are significant for both sides. Earnouts should therefore be approached with caution and structured with care.
Avoiding Earnout Disputes
Firstly, use earnouts selectively, and structure them carefully at the ‘deal’ stage
Don’t propose an earnout in circumstances where it doesn’t make sense. Earnouts shouldn’t be used where the seller won’t remain actively involved in the business, or where the buyer wants to integrate the target immediately following its acquisition.
Agree the terms of the earnout structure (including the key financial metrics and accounting assumptions) early in discussion, i.e. in the letter of intent or the deal’s term sheet.
An earnout may need bank approval if the buyer is using debt to fund the deal. Get this approval early.
Don’t make the earnout so short that the seller can’t achieve any significant upside. Likewise, don’t set it so long that it remains an unnecessary distraction to the longer term development of the business.
Set targets at a realistic level. Too ambitious targets, when missed, are highly demotivating to a seller that is forced to remain working the business.
The devil is in the detail, as they say. So, engage experienced M&A legal counsel with experience of drafting earnouts.
Minimize the scope for (mis)interpreting how the earnout payment is calculated. Specifically, in the purchase agreement:
- Targets should be clearly defined, objective & simple to assess/calculate.
- Where the earnout payment is based on the financial performance of the target, the basis for preparing the earnout accounts (e.g. in accordance with GAAP) should be set out. If pre-close accounts are to form a baseline, these should be restated and approved by the parties pre-close.
- The baseline and other account/financial data used when calculating earnout payments should be analyzed on an “apples-to-apples” basis, as normalizations and GAAP adjustments are typically included within EBITDA/Net working Capital and other baseline financial data. Therefore, it is imperative that all post-close/future financial data be normalized, GAAP adjusted, accounted for with the same policy approaches.
- If the earnout is to be calculated by reference to adjusted EBITDA, agree and document the basis for any adjustments to the accounts that will be used.
- Include a mock-up of the earnout calculations in the purchase agreement.
The input of a CPA conversant with both the commercial and accounting mechanics of earnouts is vital to producing clear language and workable mechanics.
Secondly, actively manage the relationship and earnout mechanics post-close
Maintain open and timely communication. In particular, promptly share performance/financial information that will help to keep the parties aware of progress against earnout targets.
Show your commitment to a mutually beneficial outcome i.e. maximizing the earnout metrics for the benefit of both parties. This will help to maintain a strong relationship, which is the best antidote to disputes; by contrast, the absence of empathy will accelerate to litigation!
If dedicated accounts will be prepared for calculating the earnout, have a third-party CPA firm (agreed by the parties at the deal phase) prepare the accounts to ensure that this is done in a timely and rigorous way.
If the earnout is calculated by reference to performance over multiple years, agree the earnout calculation (or the relevant part of it) for each year promptly following the end of that year. This way, events are still fresh in the parties’ minds and controversies are not left to fester.
Document everything (within reason!) Keep a record of how earnout accounts are prepared, earnout targets are calculated, information shared and obligations under the purchase agreement are met (or not).
Lastly, if all else fails and a dispute seems imminent, talk through the reasons behind it and be open to revisiting the terms of the earnout.
A common option is to extend the term of the earnout to give the seller a chance to make up a shortfall. Although unappealing, this will be preferable to a protracted, costly and time-consuming dispute!
Considering M&A? Need creative advice on deal structure?
If you have questions or need help with negotiating and structuring a deal where an earnout might be a fit, reach out to Chris Perfect today by email: chrisperfect@conceptandperspective.com
Alternatively, follow CNP’s page on LinkedIn for more great M&A insights.
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