FOR EXECUTIVES SEEKING TO BUY, SELL, OR RECAPITALIZE BUSINESSES
A Guide To Structuring An Earnout
“Experience is what you get when you don't get what you want.” - Dan Stanford
Before one digs deep into the structure of the earnout it is important to understand the motivation of the parties in structuring the earnout. Is the purpose of the earnout to bridge a valuation gap based on legitimate differences of opinion about the amount of future earning streams? Does the earnout have to do more with potential business transferability issues? Is the earnout primarily about creating incentive for delivering high performance?
Historically, earnouts have been used by M&A advisors to bridge a valuation gap between the seller and the buyer. Sellers typically tend to value their business much higher than a buyer and an earnout can be great way to satisfy both parties. Astute acquirers have also used earnouts to incentivize and motivate sellers to deliver on a performance promise post close.
The above thinking has changed significantly in the recent past. The recession and credit crisis have put the acquirers in the catbird seat and acquirers are demanding earnouts primarily as a negotiating lever - sometimes in situations where none would be warranted by historical precedents.
The structuring and negotiating of the earnouts should be based on a clear understanding of the motives. Regardless of the motives, all earnouts have several key components:
Duration of the earnout: Most earnouts last between one and three years. Anything shorter than a year is typically meaningless to the acquirer. In most cases, duration longer than three years significantly increases the chance of unforeseen events impacting the business and makes projections used for earnout unrealistic. To the extent used, longer term earnouts need to be written to decrease the uncertainty and reduce the inherent risks.
Identification of milestones: Milestones for earnouts can be financial or non-financial. For financial earnouts, sellers typically prefer revenue based milestones because they are easier to achieve and monitor. On the other hand, acquirers prefer net income based milestones because revenue based incentives may motivate the sellers to drive revenue at the expense of profitability. An EBIT or EBITDA based milestone can often provide a good compromise between a buyer’s and seller’s needs. To reach a comprehensive agreement, acquirers and sellers should clearly understand the factors effecting EBIT/EBITDA, including the pre and post close accounting methods used to compute the milestones.
Operation of the business during earnout period: The goals of the acquirer and the operation of the business post-acquisition could be substantially different from the seller’s goals and the pre-acquisition operational model. For the earnouts to be meaningful, the acquired business should be operated in a predictable way that, among other things, reduces mismanagement and malfeasance on the part of both the acquirer and the seller. Employment agreements should also be put in place to ensure the seller has a say over relevant control issues. The earnout may also be adversely impacted by how the acquiring company allocates operational overhead and other expenses in the earnout calculations. A merger or acquisition of the acquiring company or the acquiring division, or a divestiture of the division or a product line, could also create situations where the earnout metrics become meaningless. It is imperative that the earnout document contain clauses detailing operational, accounting, and employment specifics and identifying conditions under which the earnout may have to be modified or accelerated.
Establishing if/when milestones are achieved: Typically it is the acquirer’s responsibility to identify when an earnout milestone is achieved and provide the calculations pertinent to the earnout. A prudent seller should ensure that he has access to audited/auditable books that relate to the earnout calculations should a dispute arise. The parties also need to establish mechanisms to deal with any challenges to the earnout calculations.
Method of payment: An earnout may be paid in cash, stocks, bonds or other securities. If the payment is made in forms other than cash, the seller needs to be cognizant of the potential variability in the payment stream. The acquirer may offer 10,000 shares of the company’s publicly traded stock at a stock price of $50 at the time of the deal and unanticipated events could result in the stock price being $5 on the day of the earnout payment - effectively driving the value of the earnout to 1/10th of the anticipated value. Earnouts paid in private company securities could be even more of a challenge as they are illiquid and are more easily subject to manipulation.
Tax impact: The earnout language should be drafted meticulously to ensure proper tax treatment of the earnout. Depending on how the earnout is written, the payments could be capital gains, payroll income or independent contractor income – all with very different tax implications. It is imperative that the language be carefully addressed to avoid conflict and to reduce the tax bite.
Earnouts, no matter how well crafted, can contain pitfalls for both sellers and acquirers. Parities to an earnout agreement must understand each other’s motives and craft an operationally workable win-win agreement that reduces scope for potential conflict and litigation. It is imperative that both parties know what they are getting themselves into with an earnout agreement.
For assistance with selling or recapitalizing your mid market company, contact:
Chakradher (Chak) Reddy
Elite Mergers & Acquisitions
2260 E. Bidwell St #1114, Folsom CA 95630
Ph: 800-335-3068; Fax: 888-502-3817
Disclaimer: This document is for informational purpose only and should not be construed as tax or legal advice. Please contact your CPA/attorney for advice on your specific situation.