Earnouts in private merger and acquisition (M&A) transactions provide for a portion of the purchase price to be paid to the Seller contingent upon the target company reaching certain financial targets or performance milestones following the closing. Earnouts are typically among the most heavily negotiated provisions in a private company acquisition and are highly susceptible to disputes following the closing. In this blog, we highlight some of the key considerations and potential issues in structuring an earnout.
When is an Earnout Used?
Earnouts may be used in the following scenarios:
- When the Buyer and Seller cannot reach agreement on the valuation.
- When a target company has high potential for growth but does not have a track record to give the Buyer enough comfort that the growth to justify a higher purchase price will be achieved.
- To encourage the continued engagement of the Seller or other key executives in the target company’s success following the sale.
The Buyer’s Perspective
Buyers often view an earnout as providing several advantages. An earnout can prevent a Buyer from over-paying for the target company because a portion of the value will be based on the target company’s actual future performance versus anticipated or predicted future performance. In addition, an earnout allocates to the Seller a portion of the risk of the target company’s future performance.
On the other hand, in order to protect the integrity of the business deal between the Buyer and Seller around the earnout, Sellers sometimes negotiate the inclusion of restrictions on the Buyer’s operation of the target company post-closing as part of the earnout provision. These restrictions may include limiting the Buyer from making certain operational changes or limiting the integration of the target company into the Buyer’s pre-transaction business during the earnout period. The Buyer may also view an earnout provision as a risk if the Seller continues to manage the target company during the earnout period and does so in a manner primarily focused on achieving the earnout in the short term to the detriment of the target company’s long-term performance following the closing of the transaction.
The Seller’s Perspective
Generally, we advise Seller clients to negotiate for receiving all or as much of the purchase price consideration as possible at the closing, and not pursuant to an earnout. However, if the Seller is satisfied with the purchase price received at closing, that Seller may find an earnout attractive because it provides the Seller the opportunity to realize a premium on the purchase price relative to what the Buyer otherwise might have agreed to pay. With any earnout, the Seller should be confident that the earnout targets can be realistically achieved post-closing.
Some Sellers view earnouts as disadvantageous because they defer and make contingent a portion of the purchase price or may tie Sellers to the target company for a longer time period post-closing than those Sellers may desire. Achievement of the earnout may also be completely or largely in the hands of the Buyer in instances where the Seller is not involved in the target company after the closing or does not have operational control. Further, if the Buyer has latitude to make material changes to the management, structure, or operations of the target company following the closing, the earnout targets can be at risk.
Key Considerations in Structuring an Earnout
Earnout provisions can vary significantly from transaction to transaction. However, several key issues should be considered with any earnout, including:
- The financial and/or non-financial targets to be achieved in the earnout. The financial and non-financial targets should be objective, measurable, and clearly defined in the purchase agreement.
- Examples of financial targets include total revenue, net income, EBITDA or some other financial measurement that is relevant to the target company’s operations.
- Non-financial targets may be appropriate when financial targets do not provide for a relevant measure of a target company’s performance. For example, with an emerging technology company with limited revenue on which to base a financial target, the parties may instead agree on non-financial targets, such as achievement of certain operational or product development milestones.
- The length of the earnout period, the timing of the earnout payments, and the formula for determining earnout payments. These terms are largely driven by the financial or non-financial target chosen by the parties as well as, with respect to the earnout period, potential tax considerations for each party.
- Form of Earnout Payment. The parties will need to agree on whether the earnout payment will be made in cash, which is typical, or in some other form of payment, such as the issuance of equity in the Buyer.
- Procedures and Dispute Resolution. The parties should always carefully consider the procedures for calculating and verifying any relevant financial target for each earnout payment. In most cases, the parties agree to involve an independent third party, such as a mutually agreed upon accounting firm, to determine the calculations in the event of any objection to the earnout calculation.
Properly structuring an earnout is often a critical component of a successful private company M&A process and outcome. The attorneys at Linden Law Partners have extensive experience drafting and negotiating M&A purchase agreements, including all aspects of earnout provisions, that address the dynamics of each individual transaction. Please contact us here or call us at (303) 731-0007 to discuss how we can help you evaluate or structure an earnout as part of any M&A transaction that you may be considering.