At the heart of a business acquisition is the valuation of the business itself, and on this, sellers and buyers may be far apart. The seller usually points to strong growth trends or an industry with positive momentum, and the buyer might emphasize uncertainties in financials and risk in the marketplace. Sellers’ expectations on valuation are sometimes high, while buyers may be hesitant to pay premium value for the businesses without some guarantee of performance.
When there is a difference in valuation but both parties desire to get the deal done, an earnout may be used to bridge the gap. An earnout is an option for the buyer to condition a portion of the purchase price on future performance of the business. By shifting payment of a portion of the purchase price to a future date and then only if certain conditions and terms are met, the seller can maximize the value of the business, and the buyer can reduce risk.
Earnouts can be extremely complicated or relatively simple, depending on the transaction, but they are never cookie-cutter and have a relatively high risk of future litigation or arbitration unless carefully considered, crafted and documented on the front end.
An earnout provision may be included in the initial letter of intent or come into the negotiations at later stages if valuation becomes an issue after due diligence. The valuation of the business may differ between the parties because the business is too young to allow for an accurate prediction of its future performance or there may be uncertainty in the market in the industry.
The term of an earnout is typically 1-3 years and generally 15-30 percent or more of the total consideration may be tied to the agreed upon metrics. The seller usually continues to remain involved in the business for the period of the earnout to ensure that economic or performance incentives are achieved. But the buyer controls the business after the transaction, so the buyer might take actions or make changes to the business that may seem to harm the seller’s ability to meet the conditions of the earnout.
Accordingly, the seller should require the buyer to run the business as it was run prior to the transaction by maintaining a similar level of funding, a minimum number of sales people, key employees, limiting additional overhead, etc., or make adjustments to the calculation in the event changes are made by the buyer. The likelihood of dispute increases with the complexity of the calculation of the earnout.
The metrics used to measure the performance for payment must be clearly defined and understood by both parties.
Metrics may include economic earnouts (future revenue, gross profit or EBITDA) or performance earnouts (goals not directly linked to financial performance, such as product development, patent approvals, securing a large contract, etc.). Typically, sellers will prefer metrics based on revenue and buyers will tend to prefer metrics based on net income so that costs will be contained in generating new revenue. Each of these metrics can be manipulated by the buyer after the transaction, so the seller should include various protections in the purchase agreement or earnout agreement.Sellers should seek counsel to ensure that the provisions of an earnout do not put the consideration tied to the earnout at risk. Buyers should be aware that such provisions often result in litigation or dispute resolution. Many times the verification of the seller’s performance leaves room for uncertainty, and the parties’ initial inability to agree on valuation is simply delayed into the future.
It is important to identify and negotiate any specific circumstances that might impact the seller’s ability to satisfy the conditions of the earnout. Unique tax issues should be addressed in advance by the parties’ tax accountants or tax attorneys. While earnout provisions may create disputes between buyers and sellers after the transaction is closed, there are many benefits to such provisions if negotiated, structured and documented properly.
Fred M. Perkins III is an attorney of counsel with Wright Lindsey Jennings, where his practice focuses on mergers and acquisitions, corporate finance, securities, real estate development and general commercial transactions. He was previously an investment banker with Stephens Inc. and an executive with Acxiom Corp. “The Earnout Option” was featured in the January 21, 2013 issue of Arkansas Business.