What are earnouts in merger and acquisition deals?
David Rodriguez, partner at Richards Rodriguez and Skeith explains:
An earnout is a tool that parties use to bridge a valuation gap between an optimistic seller and a pessimistic buyer. An earnout essentially is a provision in the definitive agreement that measures the company’s performance post-closing and provides a seller an opportunity to obtain additional consideration based upon the performance of the company they have sold.
Typically, the parties will include a provision within the definitive agreement that provides a mechanism in which the seller of the business is permitted to receive additional consideration after closing – based upon the future performance of the company being sold.
This sounds fairly easy, right? It can be – as long as the target, or the company being acquired, will be a subsidiary (or standalone subsidiary) or a division of the buyer. The process gets complicated when the target is actually merged into one of the businesses of the buyer. This is why both parties should be careful with how they draft how the mechanism will work.
The party should clearly define the financial metrics that will be used to calculate the earnout. The metrics can include the target company’s:
• Net income
• EBITDA (earnings before interest, tax, depreciation, and amortization)
The party should also clearly define which accounting methods they will be using in the calculation – whether it’s GAP or some other agreed upon accounting method. In the drafted agreement, the party should clearly define whether the payout will be over an installment period, or whether there is a lump sum payment due. They should also agree upon whether there will be an overall cap on the amount that the seller is due in the earnout and how long that earnout period will be.
In the definitive agreement, the parties should define and come into agreement on how much control the seller will have post-closing on the business that they have sold and then, how much control the buyer will have. What does this mean for the seller? This could have a significant impact on the seller’s ability to earn part of the earnout. For example, if the seller is left with no control, the seller is left to the devices of the buyer and will have to rely on the buyer to perform and operate the company in the seller’s best interests. That can be difficult.
It’s always a good idea to proactively think about how disputes will be resolved in the future. Parties entering M&A deals should consider an arbitration provision and appointing an independent accountant to determine who is subject to an earnout payment or not. Earnouts can be an incredibly helpful tool in merger and acquisition transactions – as long as the parties clearly define critical details, such as: how it works and how long it will be in place.