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What happens when the buyer and seller of a business really want to make a deal but can't agree on a price? In many cases there is no deal, and the parties go their separate ways. In some cases, however, the parties are able to salvage the deal despite their differences by using an earnout.

What happens when the buyer and seller of a business really want to make a deal but can’t agree on a price? In many cases there is no deal, and the parties go their separate ways. In some cases, however, the parties are able to salvage the deal despite their differences by using an earnout.

An earnout is an agreement by the buyer of a business (Buyer) to make payments to the seller or its shareholders (for simplicity, both the seller and its shareholders may be referred to as the Seller) only if the purchased business (Target) meets or exceeds agreed-upon performance goals following the closing. Earnouts are usually used to bridge disagreement between Buyers and Sellers as to the Target’s value. If negotiations bog down on the issue of price, an earnout can be a tempting way out of the impasse.

Earnouts are usually fairly simple to describe in principle, and seem to be a logical way for each party to put its money where its mouth is. In some deals, earnouts serve mainly to provide a post-closing performance incentive for Seller shareholders who stay on to manage the Target. Despite their obvious appeal, both Buyers and Sellers should think carefully before agreeing to an earnout. Many lawyers, accountants, M&A advisors and others experienced in dealing with earnouts believe earnouts fail to achieve their objectives more often than they succeed. If the parties decide to use an earnout, each party (and its lawyers and accountants) should negotiate carefully and pay close
attention to the details.

An earnout that makes sense in principle can become a disaster due to poor drafting, inattention to details and the law of unintended consequences. In some cases, no deal at all may be better than a deal with a bad earnout. If the Buyer is not careful, it may find that the Seller is managing the Target to maximize earnout payments at the expense of long-term profitability, or that the Seller is reaping a windfall due to the Buyer’s own efforts. Sellers may find that they are unable to achieve earnout targets because the Buyer has loaded the Target with questionable expenses, changed its business strategy, provided insufficient capital or taken Target market share by promoting competing products. Unforeseen events, such as a Buyer change of control or fundamental shifts in the marketplace, can undermine the basic assumptions of the earnout and cause problems for both parties. Earnout disputes are fairly common, and they sometimes result in
expensive litigation or arbitration.

This article outlines some of the key issues that Buyers and Sellers should consider in structuring and negotiating an earnout.

When Are Earnouts a Good Idea?

Earnouts work best when all of the following conditions apply: (i) there are honest differences of opinion about the value of the Target; (ii) the Target will be operated on a stand-alone basis during the earnout period; and (iii) the Seller will be managing the Target during the earnout period.

If the Target will be thoroughly integrated into the Buyer’s business during the earnout period, both parties should think twice before agreeing to an earnout. The problems of defining the earnout targets, specifying accounting policies, excluding inappropriate expense and income items and providing for the unexpected are challenges in all earnout situations. These challenges are especially daunting if the Target’s operations will be combined with another business. The Seller usually bears most of the additional risk in this situation, but it can also be a problem for the Buyer, who may end up rewarding the Seller for synergies or other improvements that were due entirely to the Buyer’s own efforts.

Sellers should be especially leery about an earnout when the Seller’s former shareholders will not have an active role in Target management following closing. Even if the Buyer seems trustworthy and the Seller is trusting, there are too many ways for the Buyer to undermine the potential value of the earnout, whether through intentional acts, mismanagement or focusing on other priorities. From the Seller’s perspective, no one will be as focused on achieving the earnout targets as the Seller. An ongoing management role is the best way for the Seller to make sure the Target’s efforts are concentrated on achieving the earnout goals and the Buyer is not playing games with the earnout calculations.

It is not unusual for Sellers to go into purchase price negotiations using inflated and unrealistic post-closing projections for the Target. The Buyer may call the Seller’s bluff by proposing an earnout. The result in some cases is an earnout that neither side really expects to be achieved. Sellers should keep this possibility in mind when they prepare their projections.

What Are the Metrics?

Earnout payments are usually contingent on the Target meeting or exceeding financial performance goals. Financial performance measures may include any of the following:

  • Gross Sales — This is often best for the Seller, since gross sales are easy to measure and difficult to manipulate. From the Buyer’s perspective, however, the key measure of business success is profit rather than sales. The Buyer recognizes that increased sales often come at the expense of profits, and will be reluctant to create incentives without some profit discipline.

  • Net Income — From the Buyer’s perspective, net income is usually the most important measure of performance, literally “the bottom line.” For the Seller, a net income target can be problematic since bottom line income comes only after deduction of all expenses, including interest, depreciation, amortization and tax. In many cases, these expenses are determined by factors other than the business performance of the Target. Expenses may include, for example, interest expense on debt used to finance the acquisition, increased depreciation due to the Buyer’s stepped-up tax basis following the acquisition and arbitrary allocations of Buyer administrative overhead. A Seller will therefore want to avoid net income in favor of measures further up the income statement.

  • EBIT or EBITDA — EBIT (earnings before interest and tax expense) or EBITDA (earnings before interest, tax, depreciation and amortization expense) are probably the most frequently used performance measures for earnouts. They focus on the Target’s cash flow and eliminate some of the expenses that are most problematic for the Seller. In many cases, the base purchase price for the Target is calculated based on a multiple of EBIT or EBITDA, so it is logical to use the same measure for the earnout.

In earnouts with financial targets, the amount of the earnout payment is often expressed as a percentage or multiple of the amount by which the Target’s results exceed the financial target (e.g., 3.5 times the amount by which EBITDA exceeds $10 million). Sometimes earnouts are based on non-financial milestones, such as bringing a product to market or obtaining regulatory approval.

In most earnout arrangements, the Target must reach an annual performance threshold before the Seller is entitled to any earnout payment. Sellers often argue for some proration if the threshold is not met. Buyers seldom agree to this but may lower performance targets to compromise. Sometimes there is an annual payment if the Target meets its threshold for that year, and in other cases the Seller must hit the threshold in each year of the earnout period in order to qualify for a single payment at the end of the multiyear period. In a multiyear earnout, Sellers should ask for the right to use excess performance in good years to make up shortfalls from bad years, or to average results over the full period. Buyers should consider capping the total potential payout under the earnout.

Earnouts typically cover periods ranging from one to five years. Two or three years is probably ideal — if the earnout period is too short, both parties will have an incentive to manipulate results by artificially loading sales (in the Seller’s case) or expenses (in the Buyer’s case) into the earnout period. This kind of manipulation is more difficult over a longer period. If the earnout period is too long, it is more likely the Sellers will be rewarded for the Buyer’s post-closing work rather than the pre-closing potential of the Target, or that unanticipated developments will upset the assumptions on which the parties based the earnout.

The Devil is in the Details

In most earnout situations, agreeing to the basic earnout formula is the easy part. The hard part is in the details: What accounting methods will be used? What revenues or expenses should be adjusted or disregarded? Who controls the accounting? What happens if there is a dispute?

Since the Buyer will usually control the Target’s accounting post-closing, the Seller has the most to lose if it does not pay close attention to accounting methodology. The Seller’s goal is to make sure the earnout calculation provides a fair, apples-to-apples comparison between the Target’s pre-closing and post-closing operations. The baseline methodology is usually generally accepted accounting principles (GAAP) applied consistently with the Seller’s pre-closing practices. It is in the interests of both parties (and the Seller in particular) to provide additional details in the earnout agreement regarding accounting methodology. GAAP permits a wide range of accounting policies, and often there is room for disagreement regarding the Seller’s past accounting practices. The parties and their accountants should try to identify in advance the areas most likely to cause problems and agree on detailed accounting procedures for those areas. Problem areas might include:

  • Depreciation
  • Inventory
  • Employee benefits
  • Bad debt and other reserves
  • Current expense vs. capitalization

In many earnouts, the most difficult issues to negotiate are exclusions, adjustments or caps demanded by the Seller to ensure that the Buyer does not charge inappropriate expenses against the Target’s earnings. Sellers frequently ask for exclusions, adjustments or caps in the following areas:

  • Allocation of Buyer’s corporate overhead charged to the Target
  • Management or other fees charged to the Target by the Buyer or its affiliates
  • Amortization of goodwill from the acquisition of the Target or later acquisitions
  • Extraordinary expenses (the Buyer may want to exclude extraordinary income)
  • Capital expenses unlikely to be recouped during the earnout period
  • Interest charges on acquisition debt
  • Target transactions with affiliates on anything other than arm’s-length terms

Both parties have valid concerns with these issues, and it can be difficult to draw a line in advance to distinguish legitimate expenses from abusive ones. Even when parties can agree in principle where to draw that line, the drafting can be a nightmare.

Who Runs the Show?

Another difficult subject in earnout negotiations is the degree of control the Seller will have over the Target’s post-closing operations. In many earnout situations, one or more of the Seller’s shareholders will continue to be employed as senior managers of the Target following the closing. When the earnout is proposed, the Seller often assumes it will have carte blanche to run the Target as it sees fit through the end of the earnout period. The Buyer usually sees things differently. The Buyer is, after all, buying the Target and expects to have final say in how it will be run. The Seller often wants written assurances that it will have autonomy to manage the Target in a way that will maximize earnout payouts. Buyers understandably resist this, and Sellers are usually unsuccessful in getting detailed autonomy rights into the earnout agreement. Some earnout agreements provide that both parties will participate in preparation of annual budgets or business plans for the Target, and that the Target will be run according to the annual plan unless both parties agree otherwise.

Sellers also try to protect themselves by restricting the Buyer from taking actions that could hurt the Target’s ability to meet its earnout goals. The Seller may, for example, want to prohibit the Buyer from acquiring a competing product line or making large capital expenditures that will not benefit the Target until after the end of the earnout period. The Buyer usually resists any limits on its ability to make fundamental business decisions. As a compromise, the parties might agree that the Buyer is free to take the actions the Seller wanted to restrict, but the financial impact of those actions will be disregarded for purposes of the earnout calculation.

If the earnout is based on assumptions that the Buyer will be contributing in specific ways to the post-closing performance of the Target, the Seller should do its best to make sure those assumptions find their way into the earnout agreement. Buyer contributions might include, for example, guaranteed levels of working capital, access to the Buyer’s sales force, commitments for advertising and promotion or sharing of production facilities. If the Buyer’s response is for the Seller simply to trust the Buyer, the Seller should keep in mind that it may not always be dealing with the same cast of characters on the Buyer side, and institutional memories can be short.

In some cases the parties recognize the futility of trying to identify and provide for every contingency that might have an unfair impact on the earnout. In these situations it is not unusual to see vague provisions in the agreement (usually at the Seller’s request) to the effect that the earnout calculation will be subject to equitable, good-faith adjustment in light of the parties’ original intent if unforeseen events lead to a material unfair result. This kind of language will be difficult to enforce, but in some situations (especially for the Seller), it is better than nothing.

Early Buyout

Both the Buyer and the Seller should consider whether to ask for the right to an early buyout of the earnout under some circumstances. The Seller might request a mandatory buyout by the Buyer in circumstances which increase the Seller’s credit risk or alter the parties’ original assumptions. These might include, for example, a sale of the Target or a change of control of the Buyer. The Buyer may want an optional early buyout right. An optional buyout can protect the Buyer against situations where the earnout hinders the Buyer’s ability to take important actions, or where it becomes clear that the earnout formula was flawed, causing inappropriate incentives or an undeserved windfall to the Seller. If there is an early buyout right in favor of either party, the buyout price is usually the subject of lively negotiations.

Getting Paid

If the Seller succeeds in hitting its earnout targets, it wants to be sure it will get paid. If there is any doubt about the Buyer’s ability to pay the earnout when the time comes, the Seller should ask for security, such as a letter of credit or money in escrow, as well as acceleration or buyout of the earnout if the Buyer defaults in making any earnout payment. The Seller should also make sure the Buyer’s credit facilities do not restrict the Buyer’s ability to make earnout payments as they become due. In leveraged transactions, the Buyer’s lenders often ask the Seller to subordinate its right to earnout payments behind the Buyer’s obligations to the lender. The Seller should find out early in the negotiating process whether there will be a request to subordinate earnout payments. The Seller should also ask for interest to begin accruing at a punitive rate if the Buyer does not make an earnout payment when due. This will discourage the Buyer from withholding payment to gain leverage in a dispute.

The Buyer frequently wants the right to deduct from the earnout payment any amounts the Seller owes the Buyer under the indemnity provisions of the purchase agreement. The Seller should resist this, and should not agree to any setoff right that permits the Buyer to withhold payment until there has been a final determination that the Seller owes the Buyer an indemnity payment.

If the earnout payments will be in stock rather than cash, the parties must decide how to value the stock. Should it be valued at the market price on the closing date, or the price on the date payment is due or using some other measure? There are good arguments for each position and no objectively correct answer.

What If We Can’t Agree?

Disputes over the calculation and payment of earnouts are fairly common, so both parties should pay attention to dispute resolution provisions. In most earnouts, the Buyer and its accountants make the initial calculations to determine whether the Target has met the earnout thresholds. Sellers usually insist on the right to review and dispute the Buyer’s calculations. If the Buyer and Seller cannot agree within a relatively short time, there is usually a provision to submit the issue to an independent accounting firm for a final, binding decision. Both parties are well served by providing for binding resolution of accounting issues by independent accountants and binding arbitration of other earnout disputes. Litigation through the court system, and in particular the jury system, is not a good way to resolve earnout disputes.

Tax Issues

An earnout can have significant tax implications for both sides, so each side should have its tax advisors review the agreement before it is finalized. Potential tax issues include capital gain versus ordinary income treatment of earnout payments, the possible impact of the earnout on transactions structured to defer taxable gain, and the possibility of imputed interest.

Conclusion

If an earnout is well thought out and competently drafted, it can be a beneficial tool under the right conditions for bridging a gap in purchase price negotiations. An earnout is seldom a perfect solution, however, and each party (Sellers especially) should consider carefully whether an earnout is appropriate in its particular situation. In addition, earnouts are usually difficult to negotiate and draft. The parties should consult with their legal, accounting and tax advisors as early as possible in the process. Drafting the earnout should not be left until the night before closing.

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