Introduction to M&A Earnouts

M&A earnouts can help you get deals done . . . but not without risk.

An earnout is a deal financing mechanism where the buyer agrees to make future payments to the seller if certain agreed-upon financial or operating targets are reached after closing. The future payments are usually in addition to amounts paid at closing and can be in the form of cash, stock or bonds or a combination of any of them. The performance targets are typically based on the future earnings or sales of the target in the one to five years after the deal.

Earnouts have been widely employed in a variety of industries and can be critical to getting a deal done when the parties’ views on the value of the target business are too divergent to agree on price up front. For example, that target company you have been eyeballing may be a privately-held start up with a patent portfolio that has promising, yet unproven, commercialization potential. The company’s founder may be more optimistic about its prospects than you but wants to sell today, perhaps because the company needs access to more capital to fund growth. She thinks the company is worth about $100 million. Nonetheless, while you’re intrigued by the company’s technology, you aren’t convinced it will achieve broad enough market acceptance to yield an acceptable return at the seller’s valuation. You would say a more realistic valuation is in the $75 million range.

So you compromise. You agree to an up-front cash payment of $50 million with as much as $50 million more if the target business performs consistently with the seller’s projections over the next three years. You call your lawyers and tell them to start working out the details.

But that is just where the devil is lurking. Failure to get the details right can transform your deal from accretive to ruinous. Post-closing disputes over earnouts are common, with disputes generally centered around whether the performance target calculation was performed properly and whether each party complied with any covenants that could have impacted the achievement of performance targets.

Consider what metric you’ll use for performance targets. You have a broad set of options, including revenues, sales (gross or net), gross profit, operating income (EBIT), operating cash flow (EBITDA), net income or the occurrence of specific contingencies, such as receipt of favorable regulatory approvals. The farther down the income statement the line items included in the earnout formula appear, the more susceptible the results are to accounting judgments and possible manipulation.

On the other hand, the farther down the income statement the line items included in the earnout formula appear, the better the line items reflect the actual financial benefit to the buyer of the acquired business. If practicable, the use of audited financial statements will serve to reduce potential disagreements. Limiting the parties’ ability to manipulate future financial results while enabling them to rely on performance measures that reflect real value to the buyer requires agreeing to detailed, well-defined formulas. So, to reduce the risk of earnout disputes, accounting methodologies should be consistent with those historically used by the seller.

The treatment of certain items should also be specified in the earnout formula, which may include one or more of the following:

• amortization of the goodwill incurred in the transaction,
• the amount of overhead (i.e., accounting, legal, public relations, advertising and other shared expenses) charged to the acquired company,
• R&D expenses,
• interest on the buyer’s capital contributions to the target,
• capital gains,
• capitalization of expenses,
• affiliate transactions,
• pension costs,
• fixed asset depreciation,
• income or charges from extraordinary or non-recurring items and
• income derived from newly acquired operations financed by the buyer.

In addition, the earnout formula should address the treatment of contingencies, which could include a force majeure event, the buyer’s decision to sell the business before expiration of the earnout period, the target company’s failure to receive anticipated regulatory approvals, the departure of key personnel and so on. Agreeing on the formula for calculating performance targets, however, mitigates only some of the risks inherent in using earnouts. Because the ultimate price payable through an earnout depends on future performance, the parties must enter into the transaction knowing how the business will be operated going forward.

Ordinarily, buyers manage the business post-closing, but sellers will expect the business to be operated in the ordinary course consistent with past practice or otherwise be compensated for losses attributed to deviations. Sellers may also request approval rights or other involvement in major business decisions, such as expansion plans, hiring or firing key personnel, capitalization, dividend policy or combining the business with other businesses. Although a buyer will of course resist perceived encroachments on its ability to manage the acquired company, it is prudent to agree upon reasonable, objective parameters for operations during the earnout period to avoid grounds for later disputes.

These and other complexities associated with earnouts must be managed carefully and with due regard for their susceptibility to dispute. Learning to do so can make the earnout a useful tool in your implementation of successful M&A transactions in uncertain times.

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If you’d like to read more about earnouts, here‘s a detailed presentation I prepared on the subject.