What is an earnout?
In the context of a mergers and acquisitions (M&A) transaction, an “earnout,” is a mechanism used to structure the purchase price paid for a company. In many transactions, buyer pays seller the entire purchase price at closing. In others, buyer and seller agree to a purchase price structure where a portion of the purchase price will be paid at closing, with an additional amount paid post-closing under certain circumstances. Payment of the earnout is contingent on the company’s post-closing performance or the achievement of specified financial targets within an agreed timeframe.
Are earnouts common? When are they used?
M&A practitioners employ earnouts under a variety of circumstances. The prevalence of earnouts can vary depending on various factors, including the industry, size of the transaction, and risk associated with the business. When buyer acquires a company intending to integrate it into an existing business, earnouts are less common. When outside financing is difficult to secure, an earnout can present a compelling financial opportunity for both buyer and seller. Negotiating an earnout can help bridge the gap when buyer and seller struggle to agree on the company’s valuation. When the future performance of the company is uncertain, an earnout can provide comfort to a risk averse buyer so that the deal can proceed. In other cases, buyer may use an earnout to incentivize seller to join the company’s post-acquisition management team.
Key Terms Earnout terms should be carefully negotiated and memorialized in the purchase agreement for the company and may include the following.
Earnout Amount and Performance Metrics
The earnout amount is the additional payment that buyer agrees to pay seller if specific performance metrics are met. Performance metrics can include financial targets or business-related milestones. Calculations related to the attainment of performance metrics can be complex. The earnout amount can be a fixed figure or it can be calculated based on the attainment of specified financial targets, with buyer receiving a larger earnout amount if specified performance metric thresholds are surpassed.
Earnout Period and Payment Structure
The earnout period is the timeframe during which performance metrics must be achieved. The period can range from a few months to several years. For longer earnout periods, the parties usually agree to specific dates on which performance is measured to determine whether performance metrics have been met. Earnout payments can be structured in various ways, including lump sum payments, installment payments, and payment of a percentage of future profits. Of course, if performance metrics are not met by the expiration of the earnout period, no earnout payment is due.
Advantages and Disadvantages of an Earnout
Agreeing to an earnout has advantages and disadvantages. Whether you should agree to an earnout will depend on your specific circumstances and priorities. As seller, are you seeking to retire or are you interested in joining the management team to help grow the business and realize future profits? As buyer, are you seeking to mitigate risk related to the company’s valuation and benefit from the experience and expertise of seller post-acquisition, or are you planning to acquire the company and integrate it into your existing corporate structure?
A seller who believes that the company will perform at higher levels post-acquisition can potentially achieve a greater overall purchase price through an earnout. Reaching performance metrics can be challenging, as seller will not have complete control over the business once it has been sold. Seller’s ability to receive the earnout will be impacted by buyer’s actions, strategy, and management approach.
Alignment of Interests
Earnouts seek to align the interests of seller and buyer. Under ideal circumstances, buyer and seller contribute different resources to the business post-acquisition. Seller brings specialized knowledge and industry-specific skills critical to the business’s success. Buyer provides access to capital, technology, a broader customer base, or industry and client relationships. Seller seeks to meet or exceed performance metrics and receive the earnout amount. Having a financial stake in the company’s post-acquisition success, seller is incentivized to ensure a smooth ownership transition and invest in the company’s future growth. Buyer aims to realize a return on the investment, as performance metrics are met. This construct ensures that buyer and seller benefit from the success of the business and bear the impact of underperformance.
Day-To-Day Control and Management
In addition to the purchase agreement, buyer and seller may enter into an agreement setting forth the parties’ responsibilities, major decisions that require buyer’s consent, and the level of control buyer and seller will have over day-to-day operations during the earnout period. If seller retains control, buyer will require seller to prepare regular performance reports, financial statements and other information used to evaluate seller’s progress toward attaining performance metrics. If management and information rights provisions are not drafted well, the transition from owner / seller to a member of buyer’s management team could present challenges.
Non-Competition and Non-Solicitation Provisions
Although earnout provisions seek to align buyer and seller interests, buyer frequently requires seller to agree to restrictive covenants in connection with the sale of the business. Restrictive covenants include non-competition and non-solicitation clauses. Such clauses restrict seller’s ability to compete with the business and solicit its customers or employees for a specified period within a defined geographical area. The parties must ensure that restrictive covenants are narrowly tailored, as overly broad provisions risk being held unenforceable.
Benefits and Potential Challenges
Earnout terms vary widely from one deal to another and can be complex to negotiate, structure and administer. When determining whether to agree to an earnout, it is essential for each party to assess the objectives of the deal and the likelihood of achieving the earnout performance metrics. Seeking advice from experienced M&A counsel and other financial and tax advisors will help ensure that the purchase agreement and terms of the earnout are well drafted and clearly defined. A well drafted earnout can help the parties meet their earnout period obligations, avoid disputes and lead to a successful post-acquisition transition.