Buyers and sellers in M&A transactions often disagree on the value of an acquired business and, therefore, the purchase price to be paid to the seller. This is particularly true in today’s inflationary economy of higher interest rates and lower expected returns. One way to bridge these valuation gaps is through an earnout – a contractual provision in an M&A purchase agreement whereby the buyer agrees to pay to the seller an additional amount in the future, beyond the payment at closing, if certain milestones are met.
Earnout milestones are typically financial in nature, but can also be based on non-financial metrics, such as retention of key customers, issuance of a patent or regulatory approval, or a product launch. A sample earnout provision, based on financial milestones, is shown below.
If the target company achieves gross profits between $100M and $105M during the next fiscal year, Seller will receive an earnout payment equal to 0.5% of gross profits. If the target company achieves gross profits in excess of $105M during the next fiscal year, Seller will receive an earnout payment equal to 0.6% of gross profits, provided that the earnout payment shall under no circumstances exceed $7.2M.
While earnouts can be a useful tool to resolve disagreements over upfront purchase price, they present different considerations for sellers and buyers.
A seller will focus on (a) maximizing the target company’s short-term growth, as earnout periods are typically between 1 and 3 years after the deal closes and (b) protecting the seller’s contingent payment right. Because a seller will usually not have financial or operational control of the target company following the closing, a seller will seek to do so through protective provisions in the purchase agreement. These provisions are geared at preventing the buyer from (i) operating the business during the earnout period in a way that minimizes or eliminates any potential earnout payment and (ii) manipulating financial metrics to avoid an earnout payment. For example, a seller may seek a contractual provision that requires the buyer to operate the target business as a standalone legal entity during the earnout period (to make it easier to account for the target’s performance), or prohibits the buyer from incurring non-ordinary course expenses above a certain level during the earnout period.
In contrast, a buyer, as the new owner, will want maximum flexibility to run the target company post-closing. For example, a buyer may want to make investments in the target company’s technology or facilities, which may reduce the target company’s bottom line in the short-term but benefit the business in the long-term. Similarly, maintaining the target business as a standalone legal entity may be costly or administratively disruptive to the buyer’s operations. For these reasons, a buyer may be hesitant to agree to seller protective provisions.
Notwithstanding these competing interests, it is possible to find middle ground. For example, the parties may agree to allow integration, so long as the buyer maintains separate books and records for the target company during the earnout period, or to allow unlimited long-term investments, so long as such expenses are excluded from the calculation of the target company’s performance for purposes of the earnout. To avoid future disputes, buyers and sellers should consult with experienced M&A counsel to help them navigate these issues and document the earnout terms.
