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Author: Scarinci Hollenbeck, LLC
Date: June 15, 2018
The Firm
201-896-4100 info@sh-law.comEarnouts 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.
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.
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.
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:
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 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.
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