The sale of a business is referred to as “taking one’s chips off of the table” because, the completion of the sale transaction, if carried off properly, pays the seller out and ends his or her risk in connection with the company. The seller has effectively cashed in and is free to move on with other pursuits without further concern for the investments of the company.
Sometimes, however, there is the possibility that there is extra value in the company that the buyer, for whatever reason, is not willing to purchase outright, and that the seller doesn’t want to leave on the table. Enter the earnout.
What an Earnout Provision Does
An earnout is a provision of the sales contract making a portion of the total purchase price contingent on the performance of the company following the sale. The effect of the typical earnout is to shift some amount of the valuation risk from the buyer to the seller. This can make intuitive sense -- the seller has a built-in information advantage and it's reasonable to ask the seller to back up representations about the state of the company by keeping some skin in the game.
The setup of an earnout arrangement can be as simple as: “if the EBITDA is greater than 1m into year post closing, the seller will receive a payment of $50,000”. Benchmarks and payments structures can get infinitely more complex from there, but that’s the idea.
Factors Complicating Earnout Arrangements
In theory, earnouts accomplish the goal of appropriately valuing the company by separating the “X-factor” of ongoing return on assets from the more readily ascertainable book value and making that X-factor valuation dependent on performance of the assets during the earnout period. In practice, it gets murkier. The theoretical virtue of an earnout arrangement relies on the notion that the company will be operated in the same manner as it has been historically, with the same market response to its operations. This makes a lot of assumptions about the buyer, seller, company, and market that rarely play out in real life. New buyers bring different strengths, weaknesses, goals, and obligations regarding financing. Market conditions change. Competitors will seek to use the transition period to their advantage and the buying and selling parties will seek to use the knowledge, control, and influence they have over the company to establish earnout rules and circumstances that benefit their interests.
Earnouts can work but they need to be crafted carefully by the parties; filling the blanks of a benchmark and payment amount may give everyone the warm fuzzies up through closing, but that won't last. Poorly developed earnouts can lead to results completely out of line with the goals of the program.
Making Earnouts Work
Consider a buyer who installs inept management that loses the faith of the workforce, leading to production decreases and missed benchmarks. This has nothing to do with the fundamentals of the company as sold – but it may well crater the seller’s earnout prospects. Likewise, a buyer who brings a sales team that aggressively pursues new markets might easily surpass a revenue benchmark even if the company was losing steam and would otherwise have been unable to live up to the seller’s promises. Here the seller likely benefits from the buyer’s superior management, and the earnout improperly rewards a seller that overstated company performance. These are easily identifiable bookends, but companies and markets are complicated, and it is almost impossible to establish a reliable apples to apples comparison of a company’s returns, segregated from managerial prerogative at two different times with two different management groups. This means that there is always going to be significant ambiguity in how to properly measure and value company performance in an earnout period.
There are situations that more easily lend themselves to fair earnouts. A transaction in which the seller and management team are to stay on board or have a significant hand in the operation of the company after close is a good candidate for a workable earnout, earnouts, as is a situation in which the seller retains equity or takes an equity position in the buyer.
The lesson from these scenarios: look for ways to keep the interests of the buyer and seller aligned before and after closing. Aligning interests can get the parties on the same team for setting guard rails on the operation of the company assets, but it doesn’t get all the way home in establishing exactly how performance will be measured and what safeguards will be in place to protect the interests of the parties. Keeping aligned interests front and center, the parties need to use their knowledge of the company and market to establish a comprehensive set of terms, accounting procedures, dispute resolution procedures, and safety valves to ensure that they continue to be on the same team. Critical factors here:
Define terms well. Establish all details of the earnout arrangement in unambiguous detail. Describe the performance benchmarks, control provisions, covenants of the parties, payment schedule, accounting procedures, and dispute resolution measures in clear and objective terms.
Use objective measures. All measures of performance should be based on objective and independently discernable.
Develop accounting and dispute resolution procedures. It is often preferable to maintain historical accounting procedures employed by the company, even if these need to be run in parallel with accounting practices of the buyer. The Seller may wish to allow for independent review if company financials by the accountant historically employed by the seller as a way of ensuring that financial reporting is on par with historical practices. The parties will likely also want to include the possibility of review by a completely independent third-party accountant as final word on any dispute. These provisions should also clearly establish how these services are being paid for.
Make sure there’s a backup plan. Consider an early termination or buyout option as a safety valve in case of the death or disability of the seller or a change of control by the buyer. This is especially important if the earnout structure is predicated on a management structure that includes the seller's management team.
Earnout provisions can be very effective at allocating risk in valuating company assets and can make deals possible by bridging valuation gaps between the buyer and seller. To be effective, earnout provisions need to be drafted to suit the specific circumstances of a transaction. An earnout provisions should never be copied from another transaction or a google search. Poorly drafted (or well drafted but ill fitting) earnout provisions can be fertile ground for disappointment, dispute, and excessive legal and accounting fees that eat away at the value of the transaction for both sides. If you’d like to discuss a transaction with a potential earnout agreement, contact Stock Legal.
