An earnout is a contractual provision used in mergers and acquisitions law (M&A) where part of the company’s purchase price is contingent on the acquisition target’s post-closure financial performance.
In other words, the seller essentially “earns” a payout from the buyer if the latter achieves a certain specified goal. Such an arrangement may be made in lieu of the seller reducing the overall purchase price.
Earnouts make up nearly 30% of M&A deals and are often a great acquisition strategy for buyers and sellers who can’t agree on a price or perceive the company’s future performance differently. These types of acquisitions become increasingly prevalent during times of high capital costs, as they give the buyer power to negotiate the sales price.
In this way, an earnout can bridge the gap between buyers and sellers who might disagree on price or performance, offering benefits to both parties concurrently. However, while earnouts may seem simple on the surface, the parties involved can encounter various pitfalls along the way, which could result in overpaying or, worse, costly litigation.
With that in mind, it’s important to work with an experienced mergers and acquisitions lawyer who understands the nuances associated with earnouts to make sure you’re getting the best deal with limited risk.
What Are Earnout Provisions in M&A Deals?
Earnout provisions are contractual clauses within a purchase agreement that secure additional compensation to the seller after close. The additional compensation is contingent on the business achieving specific negotiated targets within an agreed-upon time frame.
In short, an earnout provision allows the seller to maintain an interest in the company post-close while the buyer gets a lower purchase price. The core of the provision lies in the negotiated financial targets.
Key Considerations for Earnout Payments
To better illustrate how earnouts work, imagine this simple scenario: a seller agrees to a reduced purchase on the promise of an additional $100,000 over three years post-close if the business meets certain predetermined financial targets.
This is a basic example. Earnouts can be quite complex, involving sophisticated accounting principles, key performance metrics, and moving targets, as well as formulas for establishing earnout payments.
The targets of an earnout provision are financial goals that the company must meet within a specified time frame for the seller to receive payment. These are often based on revenue, gross income, or earnings before interests, taxes, depreciation, and amortization (EBITDA).
The parties involved are responsible for negotiating the time frames, which could be monthly, quarterly, or annually, depending on preference. The seller forfeits the additional payment if the business fails to meet a financial target within a specified time frame.
The financial targets are defined within the purchase agreement, in which an M&A attorney will explicitly outline how the targets are to be calculated and the interval in which they are to be achieved. The purchase agreement will further detail the agreed-upon accounting standards and any additional key performance indicators.
Challenges and Pitfalls
Appealing as they can be, earnouts aren’t without their challenges.
Specifically, the parties must pay attention to three key areas when drafting an earnout provision:
Misalignment of Expectations
Clashing expectations can occur when parties fail to scrutinize the financial goals, time frames, or post-closing business actions. A seller’s optimism about the company’s performance can often run counter to the buyer’s caution. Alternatively, a buyer might decide to pivot the company’s operations in a way that reduces its ability to achieve an agreed-upon financial goal.
In Glidepath Ltd. v. Beumer Corp., a buyer and seller completed an acquisition contingent on the future performance of the business.
After closing, the buyer invested in longer-term projects and personnel training that hindered short-term profits, causing a miss in financial targets. As you can imagine, the seller wasn’t too happy — they sued the buyer for breach of fiduciary duty. However, the Delaware courts ruled in favor of the buyer even though their decision didn’t maximize the seller’s position.
As you can see, it’s important for both parties to clarify their expectations before closing a deal, taking into consideration all potential actions down the line.
Complexity of Performance Measures
Agreeing on how to measure financial performance can also be a point of contention. Disputes can arise over accounting practices, expense allocations, or adjustments for non-recurring items.
In Chambers v. Genesee Wyoming Inc., a buyer and seller disagreed on an EBITDA financial target calculation.
The buyer had adjusted its publicly reported EBITDA to the seller's detriment, resulting in a missed earnout payment. The court ultimately ruled in the seller's favor because the agreement excluded the buyer’s adjustment from its calculation.
This decision further emphasizes the importance of ensuring that your provisions are based on reasonable and accurate calculations, methodologies, and potential buyer actions.
Ambiguous Terms
Earnout agreements containing vague language, uncertainty, or undefined terms can lead to protracted litigation, with both parties feeling unfairly treated when the earnout is calculated.
For example, the parties of a merger in Fortis Advisors, LLC v. Dematic Corp. failed to clearly define the term “Company Products” for a financial target centered on Company Product sales, resulting in sales numbers that didn’t match up to the seller’s expectations.
The earnout agreement failed to accurately define the list of products in its appendix, resulting in a short count of Company Product sales, as the buyer chose not to include newer products in its earnout calculation.
It wasn’t until the court considered extrinsic evidence that it ruled in favor of the seller, allowing them to receive their entitled payout. Had the parties precisely defined the terms of the agreement beforehand, they could have avoided costly and time-consuming litigation.
Earnout Agreement Terms and Conditions
Structuring an earnout provision requires craft and foresight so the drafter can reconcile each party’s priorities and desire to shift post-close risk.
While each provision is unique to the individual deal, most provisions include the following terms and conditions:
Performance Metrics
Performance metrics can be financial, non-financial, or a combination of the two. Financial metrics often include revenue, EBITDA, or net income, with sellers favoring revenue-based targets and buyers preferring those linked to profit. Defining the calculation method is crucial, as we saw with Chambers.
Non-financial metrics involve milestones like customer retention or product launches and therefore may be more suitable for emerging companies without lengthy financial histories. When relying on milestones, it's important to clearly outline deadlines, as well as the buyer’s efforts to achieve them.
Measurement Standards
Earnouts tied to financial targets must be appropriately scrutinized to ensure that post-close financials reflect the company's actual performance. Understanding and agreeing on the acquisition target’s pre-close accounting practices and using generally accepted accounting principles (GAAP) as the baseline can ensure consistent measures.
That said, GAAP allows for some flexibility, so the agreement must specifically address potential areas of dispute, such as inventory valuation, bad debt, capitalization, reserves, contingencies, and adapting to new GAAP standards.
Further, the agreement should detail the exact calculation method used, potentially including example calculations. Notably, the parties should also consider accounting procedures for post-acquisition financial considerations like expenses and write-offs to avoid future disputes.
Earnout Period
The earnout period is the timeline for achieving performance targets that trigger the seller’s payout. This can be another point of contention, as a period that's too short risks unfair results due to economic fluctuations, while an overly lengthy period decreases the present value of the payout. One to three years is a common earnout period.
Buyers tend to favor longer periods because they give them more control over operations and set them up for potential early exit opportunities. Conversely, sellers often prefer shorter timelines because they want faster payouts.
Operational Control
As we saw with Glidepath, significant disputes can arise over business control between the buyer and seller.
The buyer typically wants complete discretion to manage the acquired business. If the seller's management remains involved post-closing, the buyer should implement safeguards to prevent them from taking excessive risks or neglecting long-term investments to enhance earnout potential.
On the flip side, the seller usually wants to restrict the buyer's actions to protect the company's ability to hit financial targets, such as stipulating that the buyer must make “reasonable efforts” to meet financial goals. Some may attempt to retain a degree of control over major decisions like asset sales, hiring/firing, debt, and dividends.
Payout Formula
The payout formula determines the earnout calculation. Binary formulas pay a lump sum upon hitting a specific target, which might include non-financial milestones. Graduated formulas pay a percentage of achieved performance, but buyers may resist them without a cap.
It's not uncommon for parties to use multiple performance metrics to deter manipulation (e.g., focusing short-term efforts or adjusting accounting measures to meet a target).
Buyers often negotiate for caps on threshold formula payouts to limit risk, while sellers may negotiate for a guaranteed minimum threshold guarantee. Installment payouts are also an option, with more complex arrangements that might include staggered threshold percentages or clawback provisions.
Consult an Earnout Provisions Lawyer for M&A Deals
Earnout provisions serve as a valuable tool in mergers and acquisitions, particularly when there’s a disagreement among buyers and sellers.
But while earnouts can help prevent friction by aligning interests through compensation contingent on future financial performance, they aren’t without inherent risks and complexities. Careful drafting and open negotiations are necessary to avoid disputes and potential litigation.
As seen in the cases highlighted previously, the success or failure of earnout provisions hinges on clarity and foresight. Consequently, legal teams need to be well-versed in the nuances of these agreements to safeguard the interests of both parties and ensure a successful transaction.
The seasoned Denver mergers and acquisitions lawyers at Sequoia Legal can help you negotiate and structure earnout provisions that are agreeable to both buyer and seller. Schedule a free consultation today.
