Sellers frequently ask, “What’s an earnout?” and “Is it a good alternative for me?” This article is written to help answer those popular questions.
An earnout is a common, rational method used to help sellers and buyers reach an agreement regarding the value of a business. It is simply a method for triggering changes in the purchase price based on the future performance of an acquired company.
The past several years have produced a difficult and challenging environment causing many companies to recognize decreased earnings and even losses. However, prior to the recent difficult years, those same companies produced consistent and attractive profits.
Considering the volatility of today’s economic climate and the fact that the most recent years have been difficult, it is not surprising that many business buyers are reluctant to pay high prices without some assurance of a company’s future performance. On the other hand, sellers most frequently are optimistic that better days will return. Sellers too often want buyers to ignore the recent past and “understand” that the buyer will enjoy all the benefits of a pending upturn. To help bridge the expectation gap between a buyer’s caution and a seller’s optimism, earnouts are now frequently negotiated so sellers may participate in the future success of the company provided the anticipated growth does occur.
However, there are risks associated with earnouts. Sellers are frequently concerned that the buyer may run the company into the ground; and thus, the seller will receive no benefit from the earnout. A properly structured Buy/Sell Agreement provides the seller with legal protection. The bottom line is that the seller must know and trust that the buyer has the right intentions, sufficient capital, and the experience to grow the business even after the seller has departed. If the seller does not have such confidence in the buyer, then another buyer should be found.
Trust, cooperation, and communication are paramount in an earnout. The seller believes that the company will prosper in the future under management of the buyer. If such growth occurs, then the seller is paid. If such growth does not occur, then the seller will not be paid under the earnout. There is commercial logic to the earnout structure. If anticipated growth does not occur, then the buyer did not overpay, which was his original concern. From a seller’s different perspective, if the seller had kept the business and not sold, the non-selling owner would lack both the original cash generated from the business sale and would own a company probably worth less as a result of the economy.
A properly structured earnout in a Buy/Sell Agreement not only provides the seller with legal protection but also minimizes the likelihood of future disputes. In a cooperative effort to minimize disputes, earnouts must be carefully structured, taking the following issues into account:
- Basis for the Earnout
Earnouts can be based on a variety of operational measures, including revenues from:
- Services and products that currently exist as of closing,
- Products that are developed in the future, but are related to the seller’s current products.
- Any sale of products or services to any of the seller’s current customers as of closing, whether derived from the seller’s products, services or otherwise.
- A particular division or subsidiary of the seller’s business.
Earnouts can also be based on non-revenue benchmarks such as the number of subscriptions sold, units produced, or website hits. Based on the nature of a seller’s business, a skilled investment banker can suggest which operational measure(s) to use for earnout calculations.
- Duration of the Earnout
An earnout can have varying time horizons. A longer duration will increase the amount of data required on which to compute the earnout and generally will increase the probability of a seller being paid. However, as time passes, the buyer’s performance becomes increasingly based upon the buyer’s management, rather than the value of the entity on the closing date of the sale. Conversely, if the acquired entity is significantly affected by a temporary event (e.g., natural disaster or act of war) and the duration of the earnout computation period is sufficiently short, the event may greatly skew the earnout computation without significantly affecting the long-term value of the acquired entity. This issue must receive considerable attention, especially given recent terrorist events.
- How to Handle Revenues or Profits from New Products or Future Acquisitions
Unless prohibited in the Buy/Sell Agreement, the buyer may have an incentive to use the know-how or other assets gained through the acquisition to compete with the acquired entity, since the buyer would not have to share those profits with the seller. In addition, the buyer may conduct a future acquisition program that could include operations or assets that are in direct competition with the seller’s business. The buyer and seller should always consider appropriate guidelines for new products of the buyer, which may directly compete with the acquired entity. Also to be considered and addressed would be the parameters for similar future business acquisitions so that revenues cannot be diverted or diluted from the seller’s earnout computation. It is critically important to work both with an experienced investment banker and a specialist merger & acquisition attorney so the seller’s interests are properly protected.
- Early Payment on the Earnout as a result of a Future Merger or Sale of the Seller’s Business
At the time of the first sale, the seller made a credit decision regarding the intentions, resources, and abilities of the buyer to grow the business and pay an earnout. In a subsequent sale of the same business, the subsequent buyer may not have the same intentions, resources, or abilities as the first buyer. Furthermore, the original seller does not want the assets that drive the earnout to be sold before the end of the earnout period. A seasoned investment banker will advise his client to consider that the buyer have an obligation to payoff the earnout at a mutually acceptable price in the event of a subsequent merger or sale of the business. Because these early payment provisions can be the source of dispute, it is again critical that the seller work only with an experienced investment banker, who will provide financial advice and business considerations together with a specialist merger & acquisition attorney, who will provide legal protection. If mutually acceptable definitions and criteria cannot be reached in a Buy/Sell Agreement, then it may be advised that the sale not occur because a potential later dispute could be very difficult without a prior written agreement on definitions, criteria, and methodology.
- Should an Earnout be based on Gross Revenue or Net Earnings?
It is typically in the seller’s best interest for an earnout to be based on gross revenue because future expense management will likely not be within the seller’s control. Conversely, net earnings measures may be more useful to buyers because net earnings may better reflect actual economic performance. Because there are more variables in determining net earnings, there is a greater likelihood that disputes may develop; however, it is entirely possible to define criteria and methodology to measure performance formulas such as Earnings Before Interest, Taxes, Depreciation and Amortization (“EBITDA”).
- How to Calculate the Earnout
The buyer and seller should mutually agree in advance on the methodology for earnout calculations. Generally Accepted Accounting Principles (“GAAP”) are often the preferred basis, but there are also options and varying practices within GAAP to be considered. For example, reserves for bad debts together with reserves for returns and allowances represent estimates, which are partially dependent on the judgments and practices of the buyer. Certain items such as chargebacks and the delivery of free goods can be especially difficult to allocate. The seller and buyer must consider and define whose accounting and business practices will govern the total calculations.
- How to Account for Revenue from Sales of “Bundled Products”
“ Bundled Products” refer to a combination of products originated from both the buyer and seller. If the selling entity is to be integrated into the buyer’s existing business, distinguishing the revenues and profits from Bundled Products could be problematic. There may also be different marketing, pricing, production and distribution decisions, which would reasonably make it appropriate to base an earnout on the combined entity as opposed to the selling entity.
- Implementing Systematic Record Keeping
The operations that drive the earnout must be accurately tracked in the buyer’s accounting system. This will often affect whether and how the accounting system of the seller’s business will be integrated with the buyer’s system. The seller and buyer will also want to consider requirements for the periodic reporting of results as well as the rights of the seller to inspect or audit the accounting records supporting the earnout calculations.
- Post Closing Oversight/Control over the Business by the Seller
- How to Handle Earnout Disputes
Properly structured earnouts work well in many business sales. Unfortunately, in our volatile economy, future performance may not meet expectations for either the seller or buyer. It is important that the Buy/Sell Agreement be clear as to the intentions, definitions, and methodology of an earnout. Unclear intentions, definitions, or methodology may lead to misunderstandings, which often give rise to disputes. Generally, private arbitration with an experienced business arbitrator is most preferable. The use of arbitration is usually faster and cheaper than settling a dispute in court, and the parties can choose an arbitrator with specific knowledge and expertise.
Both the seller and buyer together with their specialty advisors should consider all ten of the points in this article in order to communicate agreement and to avoid potential future misunderstandings and disagreements.
Earnouts are increasingly common and are effective tools whereby sellers may receive their full and desired value provided the company either maintains or grows in the future as expected by both the buyer and seller. While earnouts are highly effective and fair value calculation tools, they are complicated. Most business sales represent the largest financial transaction of a seller’s career. Therefore, it is most important that both a seller and buyer retain experienced investment bankers together with specialist merger & acquisition attorneys to represent each party. Properly structured earnouts provide an operational framework for a fair and efficient methodology enabling sellers to obtain the higher values they desire.
Charles V. Lemmon is President of C.V. Lemmon & Co., Inc., a private M&A advisory firm in Dallas, Texas. Charles Lemmon can be contacted by telephone @ (214) 207-9694 or by e-mail at cvlemmon@cvlemmon.com.