Structured Earnouts: Pros and Cons When Selling Your Business
A structured earnout is a portion of the purchase price of a business that is paid overtime at a later date contingent upon the acquired business achieving certain agreed to performance targets. Basically, the buyer agrees to pay at closing a certain percentage of the agreed to purchase price with the commitment to pay additional amounts (the earnout) to the seller if the acquired business achieves certain future revenues and profits.
Structured earnouts increase or decrease sharply depending on economic conditions. During the Great Recession, economic volatility made it more difficult to accurately project revenues and profits and tight borrowing conditions made it difficult to finance transactions. As a result, buyers and sellers increasingly relied on earnouts to consummate transactions.
However, today buyers have regained confidence in the economy. Competition for quality investment opportunities has increased, creating a seller’s market for quality companies.
Therefore, sellers of high-quality companies have become less willing to enter into earnout agreements. But, for those companies for sale whose financial performance is inconsistent, who have a concentrated customer base, or are operating in poor market environments, a structured earnout could be the best option for selling your company.
Introduction to earnouts
The purchase price of a business is determined by many factors including future cash flow, earnings, growth rates, among others –- topics that are major subjects of disagreements between sellers and buyers. These disagreements often reach an impasse during negotiations because of a gap in their expectations about the future performance of the business.
The seller expects the price to reflect his/her projections on the potential future revenues and earnings. The buyer is reluctant to agree when the projections do not seem realistic. An earnout can help the parties bridge this gap and therefore complete the transaction.
The parties need to agree on what those performance targets are –- financial and/or commercial.
If they are financial, they can be set at the top of the P&L statements (e.g. gross revenues or net revenues), or at the bottom of the P&L statements (e.g. EBIT or EBITDA). If they are commercial (e.g. diversification of the customer base, or the launch of new products) milestones can be set to measure those commercial achievements during the earnout period. Most earnouts are a combination of both.
Although earnouts are an excellent tool for bridging the gap between the parties’ expectations, they have become controversial due to the potential for future disputes. Many M&A practitioners (including this writer) question whether they are ultimately good for either party. There have been various court cases in connection with earnouts. Vice Chancellor Travis Laster of the Delaware Chancery Court famously observed in the Airborne Health case: “An earnout often converts today’s disagreement over price into tomorrow’s litigation over outcome.”
Advantages of earnouts
For a buyer, the advantages of using earnouts are hard to challenge. By deferring payment(s) of a portion of the purchase price and making it conditional on the achievement of certain performance targets, the buyer is actually transferring the risk of the uncertainty of future revenues to the seller. For a buyer, this is the most valuable benefit of an earnout, as it will only pay for those potential revenues/earnings when they are achieved. The frequency of payments and the earnout period are determined by the purchase agreement — usually paid on a quarterly or semiannual or annual basis over a one to three year time period.
Another advantage for the buyer is to use the earnout as a tool to protect itself against misrepresentations or a breach of covenants by the seller. If at some point during the earnout period, the buyer makes a claim against the seller for misrepresentations, breach of covenants or other terms and conditions, the buyer may decide (depending on the purchase and sale agreement) to deduct the amount of its indemnity claim from any earnout payments due to the seller.
Finally, earnouts can help a buyer retain key employees. For example, when the seller is also the CEO of the business, having an earnout would encourage him/her to remain with the company after the transaction closes. For the seller, remaining with the company would give more control and a strong personal incentive to do his/her best to meet the performance targets.
Disadvantages of earnouts
The biggest disadvantage of earnouts is the risk of post-transaction disputes. Typically, the disputes center the seller’s ability to achieve the earnout performance targets. More often than not, disputes arise when performance targets are not met because the buyer (at the shareholder level) makes certain management decisions that prevent the acquired business from achieving its performance targets.
Structuring the earnout can be a serious challenge too. If the earnout is not tailored to or in alignment with the uniqueness of the business’s operations, complications followed by disputes can arise. Since each business operates differently, even when operating in the same space, special attention to operating details is required for a successful earnout structure.
Although the risk of earnout disputes is difficult to eliminate, earnouts work best when a seller-CEO stays with the acquired company after the transaction closes because (1) a continuity of management practices will be in place; (2) the risk of disputes based on the seller’s lack of control over the company’s operations is reduced and, (3) the seller will be rewarded for his/her own performance rather than for the performance of a new management team brought in by the buyer.
Most importantly then, one should think of an earnout as creating a partnership between seller and buyer. If an earnout is structured properly, the buyer and seller become partners, sharing in the upside and downside risk of a deal.