When Are Earnouts Appropriate in a M&A Transaction?

Earnouts can play a critical role in mergers and acquisitions by helping buyers and sellers close the deal. However, because they are not appropriate in every transaction, it is important to understand how they work and how to best protect your interests during the negotiation process.

Earnout Basics

In an earnout sale, the buyer pays less money at the time of the sale but makes additional payments based on the future success of the business. The additional compensation is typically calculated based on a percentage of gross sales or earnings. 

Earnouts can be attractive to both sides in a M&A transaction. For buyers, earnouts provide an additional option to finance an acquisition and can lessen the upfront costs. When selling a business, an earnout can help obtain a higher selling price, capturing the value of the ongoing business.

Because earnout payments are tied to the future success of the sold business (or combined business), there are risks. In addition to thoroughly researching the background of the potential buyer, agreements must also be properly drafted to ensure that earnout amounts will be accurately calculated and can be independently verified.

When to Pursue an Earnout

For sellers, it can be beneficial to negotiate an earnout if your business has recently launched a new product or service because it allows you to reap the benefits of your efforts even after the business changes hands. They also make sense when a large majority of your contracts are backloaded, with sizable payments expected to come in after the deal closes.

For buyers, businesses with a steady stream of revenue (vs. singular milestone payments) are more attractive with respect to earnouts. It is also beneficial when the target’s key personnel are expected to remain with the company past the earnout period, as it helps guarantee future success. Earnouts are also frequently used when acquiring startups because they often have a short operating history but a high potential for growth.

Making Earnouts Successful for Both Parties 

For an earnout to work for everyone involved, it must be a fair partnership with clearly delineated and achievable goals. While both sides want the business to remain profitable, the seller is understandably more focused on the company’s performance in the near-term, while the buyer is concerned with how the company will fit into its long-term strategy.

To avoid disputes, the following issues should be thoroughly addressed in the earnout provisions of the transaction:

• Performance Targets: Benchmarks should be readily calculated and transparent. Targets such as sales revenue, net income, and EBITDA margins are frequently used. To avoid disputes, sellers and buyers should agree to targets where the standard is clear. Non-financial targets that can be measured include new customers obtained and the number of products sold are also used, and there can be creative performance targets.
• Measuring Performance: It is equally important to establish the accounting and reporting principles that will be used to track and evaluate performance. In addition to a general GAAP provision, the parties should also address issues such as how revenue and expenses will be allocated, whether to use the cash, accrual revenue basis, or other more specialized metrics and how uncollected receivables will be used.
• Earnout Period: Earnouts with a relatively short time frame, such as a period of one to two years, can benefit the seller, while longer periods may, under some circumstances, benefit the buyer. Longer term earnouts can sometimes affect the incorporation of acquired business lines into buyer’s existing business lines, however, so buyers sometimes also prefer a shorter period.
• Payout Structure: The earnout provision must detail how payments will be made to the seller, i.e. lump sum vs. installments. It must also address any conditions to payment, i.e. earnout payments subject to seller’s participation in business and/or full satisfaction of all benchmarks.
• Control of Business: The parties must also determine how the business will be run after the transaction closes. Most importantly, the buyers and seller must agree on the level of control and participation each party will have during the earnout period. 
• Resolution of Disputes: Because earnouts involve complex financial and legal issues, the agreement should dictate the process for resolving disputes that may arise after the closing. Appointing a certified accountant and arbitrator can often resolve disagreements before they result in costly litigation.

Key Takeaway for Businesses

Earnouts can be essential to bridging the gap in valuations between the seller and buyer. When they are appropriate, it is imperative to work with a knowledgeable corporate attorney who can skillfully negotiate on your behalf.

If you have any questions, contact us

If you have any questions or if you would like to discuss the matter further, please contact me, Jeffrey Cassin, or the Scarinci Hollenbeck attorney with whom you work at 201-806-3364.