Earnouts in Mergers and Acquisitions: Structuring, Negotiation & Best Practices

Earnouts in M&A transactions offer a strategic way to bridge valuation gaps and align buyer-seller interests by tying a portion of the purchase price to future performance. When structured effectively, earnouts can mitigate risk, incentivize post-closing success, and ensure a smooth transition. At Linden Law Partners, we provide expert guidance on structuring, negotiating, and implementing earnouts that safeguard financial interests while minimizing disputes. From defining performance targets and payment structuring to addressing acceleration events and dispute resolution, our comprehensive approach ensures that earnout provisions support long-term business objectives.

Earnout Structuring and Negotiation

At Linden Law Partners, we provide experienced guidance and services related to maximizing the value of earnouts in M&A transactions while aligning the interests of both buyers and sellers. We structure and negotiate earnouts to ensure contingent payment terms are tailored to each deal’s specific objectives and circumstances.

One key aspect of our representation is helping our clients evaluate when earnouts are appropriate. We carefully assess the financial and operational context of the business to determine if an earnout fits the transaction objectives. This approach balances the sellers’ long-term objectives, buyers’ desire for risk mitigation, and sometimes helps bridge the parties’ valuation gaps.

We specialize in structuring earnout provisions that align with our clients’ transactional objectives. Recognizing that each business is unique, we work closely with clients to develop appropriate terms tied to measurable and achievable performance targets.

Negotiating earnout terms is a crucial element of many private company M&A transactions. By understanding the complexities of M&A deals, we’re able to balance buyers the concerns and objectives of buyers and sellers when it comes to earnout particulars. Our goal is to create a structure that fosters trust, minimizes disputes, and ensures both parties are satisfied with the final terms.

At Linden Law Partners, we bring clarity and strategic insight to earnout structures and negotiations, helping our clients unlock the full potential of their M&A transactions while safeguarding their interests.

Financial and Non-Financial Target Setting

At Linden Law Partners, our M&A services involving earnouts include a specialized focus on financial and non-financial target setting to ensure that earnout provisions align with both the buyer’s expectations and the seller’s performance. We understand that well-structured earnouts depend on setting clear, achievable targets, and we guide our clients through this important process.

Beyond helping parties implement their agreed-upon financial metrics for earnouts, we also support them with establishing measurable non-financial targets, when applicable. These may include operational milestones, product development goals, or other strategic objectives important for the transaction. We collaborate with both parties to define clear, achievable non-financial metrics that align with the overall transaction strategy. This might encompass key operational improvements, technological advancements, or other significant business goals contributing to long-term success.

By thoughtfully helping our clients determine and implement both financial and non-financial targets, Linden Law Partners ensures that the earnout provisions reflect the short and long-term objectives of business buyers and sellers.

Earnouts in M&A Payment Structuring and Timing

We offer comprehensive earnout-related services with a focus on the timing and structuring of earnout payments in M&A. Our team collaborates closely with clients to design earnout structures that align with business goals and transaction dynamics. We ensure that the terms governing payment timing and formulas for calculating payments are clear, fair, and practical for buyers and sellers when it comes to earnouts in M&A.

A key aspect regarding earnouts in M&A is establishing the duration and milestones involved. We collaborate with clients based on market information around the length and timing of specific milestones and performance metrics. Whether linked to annual revenue or EBITDA targets, product development, or other performance goals, we ensure the timing aligns with the target business growth trajectories and the overall deal objectives.

We also specialize in structuring formulas for earnout payments. These formulas determine how and when payments are made based on achieving financial and operational milestones. Our team helps ensure earnout formulas are transparent, straightforward, and equitable for both parties. We aim to help strike balances between buyers’ needs for protection and sellers’ desires for fair purchase price consideration.

Furthermore, we recognize the importance of tax considerations related to earnout payment structures. We help clients assess the tax implications of different earnout structures, advising on the most tax-efficient methods for structuring payments. By carefully considering these tax factors, we ensure that the earnout structure is beneficial to our clients, minimizing their tax burdens and maximizing their overall financial outcomes.

Through these services, Linden Law Partners helps ensure that earnout payment structures are clear, practical, and mutually beneficial for both parties.

Earnout Acceleration Events

With earnouts, it is essential to consider acceleration provisions to protect sellers in specific situations. Key triggering events for acceleration might include a change of control over the buyer, terminations of seller employment agreements without cause or for good reason, the buyer’s bankruptcy or insolvency, or a subsequent resale of the acquired business or its assets. By clearly defining these triggering events and their consequences in the agreement, we help our seller clients safeguard their financial interests against unforeseen changes that could erode their ability to realize their earnout potential.

At Linden Law Partners we advise on earnout acceleration provisions with intentionality considering the objectives and fair interests of both buyers and sellers.

Buyer Obligations to Support Earnout Achievement

Earnouts can be instrumental in bridging valuation gaps between buyers and sellers by tying a portion of the purchase price to the future performance of the acquired business. To ensure that earnout targets are attainable and to minimize potential disputes, it is essential to consider possible buyer obligations that support the achievement of these targets. The buyer should commit to operating the acquired business in good faith in a manner not intended to conflict with the reasonable ability of sellers to achieve earnout milestones. This involves maintaining consistent business practices and avoiding actions that could intentionally undermine the performance metrics tied to the earnout. For instance, the buyer should not divert key customers or revenue streams away from the acquired entity, reduce marketing and sales efforts, overly restrict resource allocation, or materially modify expense management in a way that could artificially suppress the earnings of the acquired business.

Linden Law Partners helps our clients strike reasonable and appropriate guardrails that help ensure post-closing actions will not be taken that could unfairly impede the achievement of earnout milestones.

Most purchase agreements should also contemplate future mergers, acquisitions, divestitures, or restructurings by the buyer that could affect the acquired business’s financial performance. Specifically, the impact of buyer divestitures or acquisitions should be considered and defined to ensure sellers are protected from corporate actions that could inadvertently or deliberately affect the ability to meet earnout conditions.

Linden Law Partners routinely structures earnouts for our clients with all of these considerations and objectives in mind to help maximize the overall transaction value for both parties involved.

Examples of Earnout Structures

There are various examples of earn-out structures that can be tailored to specific transaction goals. These include:

Example of Earnout Structure #1: Milestone-Based Earnouts: Tying earnout payments to achieving specific operational goals, such as developing a new software or technology product within a specified period following the closing.

Example of Earnout Structure #2: Financial Performance Earnouts: Payments linked to meeting and exceeding top-line gross revenue or EBITDA thresholds within a set period after closing.

Earnout Accounting Considerations

Proper earnout accounting is crucial for ensuring transparency and accuracy in financial reporting. We advise clients on:

Accounting Treatment of Earnouts. Understanding how to record earnout payments in financial statements using consistent financial principles, such as EBITDA or mutually agreed sales metrics.

Financial Principles Alignment. Ensuring the earnout accounting approach matches the agreed principles in the purchase agreement, particularly in the financial statement representations, warranties, and working capital adjustment provisions.

Fair Value Assessments. Using objective methods to evaluate earnout liabilities accurately.

Compliance with Financial Standards: Maintaining adherence to accounting standards while managing earnout accounting complexities

Dispute Resolution and Third-Party Involvement

Earnouts can lead to disputes due to their inherent complexity and performance-based conditions. To mitigate potential conflicts and ensure a seamless post-transaction experience, it is essential to establish clear dispute resolution mechanisms and consider third-party involvement. Proactively defining how earnout-related disagreements will be handled is crucial. To ensure transparency and accuracy in earnout calculations, involving an independent accounting firm is advisable. These firms can impartially verify financial metrics and performance milestones, fostering trust between buyers and sellers. This third-party validation helps confirm that earnout payments are assessed and distributed fairly, reducing the likelihood of disputes.

Disagreements over the achievement of financial or operational targets can be complex. Implementing clear definitions and measurement criteria for performance metrics within the earnout agreement is essential. Additionally, establishing a process for regular communication and review can help identify and resolve potential issues early, maintaining the integrity of the earnout structure and fostering a cooperative post-transaction relationship.

At Linden Law Partners, we consider and proactively address these issues for our clients as part of the definitive transaction agreements.

We’re here to assist you during every stage of the business lifecycle – from business formation through exit.