Earnouts: Seller and Buyer Beware

Note: A version of this article originally appeared in Kegler Brown Hill & Ritter’s ‘Anatomy of a Deal’ Newsletter

Remember when you were a kid and just about every argument ended with someone yelling, “Prove it?” Earnouts are the contractual equivalent of the Buyer telling the Seller to “Prove it” in the context of the Seller’s business.

You tell me your restaurant company can generate $5 million in profit next year, even though it only produced $3 million in profit last year? Prove it.

You tell me that your new self-ordering kiosks will revitalize sales? Prove it.

You tell me that your new delivery service will prove less expensive than relying on a third party? Prove it.

Earnouts are a useful tool to help bridge the gap between the Seller’s expectations and the Buyer’s perception of the current state of reality. The Buyer pays the Seller only if and when the business is able to prove that the Seller’s expectations turned into reality.

While the theory is sound, as you might expect, earnouts are fraught with potential traps. Usually, we talk about how the Seller is disadvantaged from earnouts, but it’s also important to know how earnouts can be problematic for the Buyer.

Here are some of the key concerns to be aware of when using an earnout.

1. Accounting and Tax Issues.
Earnouts are based on the post-closing business’s financial-, operational- or milestone-based performance metrics (or some combination of the three). Financial metrics are typically revenue or profit based. Revenue-based metrics are generally straightforward and are typically used when the new business will be integrated into the Buyer's existing business. Profit-based metrics are generally used when there is uncertainty related to revenue performance. While Buyer and Seller are usually incentivized to grow the company’s revenues post-closing, the waters can be murky when the Buyer has other businesses and product lines that target the same customers and may impact post-closing revenues of the Seller’s product.

While Sellers tend to prefer a revenue-based earnout due to its simplicity, Buyers tend to prefer earnouts based on profitability, such as gross profit or EBITDA (earnings before interest, taxes, depreciation and amortization), as a Buyer wants to protect itself from paying for low margin revenue increases, or uncertainty exists related to the sustainability of certain gross profit streams.

Once the concept of profitability is introduced, there are a myriad of issues that need to be considered. First and foremost surrounds the integration of the Seller into the Buyer’s existing business. How will the Buyer allocate overhead among the Buyer’s existing business and the new business just acquired? Integration plans are often unclear at the time of acquisition, and as such it can be difficult to determine how to treat allocations of overhead at the time of negotiating an earnout. Any new synergies as a result of the acquisition can impact profitability, and aggressive synergies built into an earnout metric have resulted in a Seller not receiving payment.

Post-closing accounting policies and procedures also need to be considered when designing a financial metric based earnout, as consistency between pre- and post-close policies can have a significant impact on any financial metric. For example, what if the Buyer’s policy is to capitalize fixed asset purchases greater than $10,000, while the Seller’s previous policy capitalized purchases in excess of $2,500? This post-close accounting policy will result in an immediate reduction in profitability. What if the Buyer is more conservative in reserving for uncollectible bad debt expense? What if the Buyer starts paying itself a management fee or hires additional, highly compensated positions? All will have a direct impact on profitability.

The purchase agreement and earnout should be structured to specifically include language on how these matters will be addressed. As a Seller, you need to realize that you will likely not have the same amount of financial and operating control as you did prior to the transaction as this is no longer your business.

Furthermore, the cash payment of the earnout will likely require additional accounting consideration. The Buyer needs to consider the valuation of the earnout and the impact on the balance sheet, as well as impact on any financial covenants.

Just as importantly, both Buyer and Seller need to assess the Buyer’s future ability to pay the earnout. Meanwhile, the Seller is generally treated as an unsecured creditor of the Buyer’s business and now sits behind the Buyer’s senior lenders – effectively putting the Seller in more of a preferred equity position in the Buyer’s company.

Lastly, earnout payments are often treated as additional purchase price and therefore may not be deductible to the Buyer in the same manner as compensation payments. Both Buyer and Seller should consider the tax impact of the earnout and determine whether an alternative structure results in a more favorable tax position.
 
2. Management and Operational Differences.
In evaluating an earnout, the Buyer and the Seller usually have their own ideas in mind about how the business will be operated after the closing. In too many instances, the expectations of the Seller and the Buyer are quite different. Sellers assume that the business will mostly continue on the same path as pre-closing; meanwhile, most Buyers expect to make meaningful changes to the acquiring company’s operations after the closing.

What if the Buyer decides to terminate or demote someone the Seller views as a key employee after the closing? What if the Buyer adds a new business line or discontinues one of the Seller’s historical business lines? What if the Buyer terminates the business’s relationship with a large customer because it’s not as profitable as the Buyer likes, or because the Buyer views that customer as a competitor in its other businesses?

Sellers oftentimes try to build in contractual protections that give them some comfort about how the Buyer intends to operate the acquired company after closing, but Buyers don’t want restrictions around how to run their newly acquired business. As such, Buyers may be in for a fight with the Seller – both during the sale negotiations and after the closing – about whether the Buyer is taking steps to frustrate the Seller’s earnout.

Sellers may seek to insert themselves into the Buyer’s post-closing management by negotiating board participation rights (whether as a full-fledged board member, an advisory board member, or as a board observer) or requiring the Buyer to provide frequent and detailed financial information to the Seller. While at a basic level, these types of rights may seem insignificant since the Seller won’t have any actual authority to dictate the Buyer’s course, this additional visibility can give the Seller ammunition to claim that the Buyer is trying to frustrate the Seller’s earnout.
 
3. Unforeseen Events.
Most earnouts extend for a period of several months to several years after the closing. But what happens if the Buyer re-sells the acquired company during the earnout period, combines it with another current or newly-acquired business unit of the Buyer, or shuts down the business, in whole or in part? Or, what if the management team at the Buyer that structured the deal is later replaced by a new management team that doesn’t understand the deal – or worse, was actively against the deal?

A well-written earnout should anticipate these types of events and provide appropriate mechanisms to address them. It’s not uncommon for an earnout to accelerate upon a subsequent change of control either of the acquired business or of the Buyer itself. However, you still have the question of what happens in that event, particularly if the earnout is a percentage of future revenue, profits, etc., which cannot be known at the time of the acceleration event.

The earnout should also – to the extent possible – be constructed to be flexible enough to accommodate even more unlikely events. For example, if the Seller dies during the earnout period, the agreement should address what happens to the earnout going forward. Does it pass to the Seller’s heirs? Does it stop altogether?

It’s impossible to structure an earnout that addresses every unforeseeable event, precisely because these events are…unforeseeable. However, a well-thought-out earnout should at least contemplate the possible – though unlikely – events that might transpire after the closing and set out the rules for what happens in that case.
 
4. Motivations.
In many cases, the Seller remains heavily engaged in the business after the closing while the earnout is in effect. While seemingly obvious, sometimes Buyers overlook the fact that the Seller’s motivations after the deal closes may be very different, due in large part to the existence of the earnout. If properly structured, these motivations may actually benefit the Buyer because they keep the Seller incentivized to help assure the seamless and profitable transition of the business to the Buyer after the closing.

However, if the earnout isn’t carefully constructed, these same motivations may encourage the Seller to engage in riskier short-term behavior at the cost of the Buyer’s longer-term business goals. For example, if the earnout rewards short-term profitability after the closing, the Seller may decide to forego expenditures that may be beneficial to the longer-term growth of the acquired company.

If not properly managed, the Seller’s short-term strategy of maximizing the earnout can be catastrophic to the Buyer, as the Buyer not only has to pay for an inflated earnout, but is left with a business that hasn’t been properly managed for long-term growth. Earnouts are most successful when the earnout is designed to align with the Buyer’s business objectives.
 
5. Disputes.
All of the above issues lead us to the frightening – and relatively common – possibility that the Buyer and Seller become embroiled in a dispute over the earnout after closing. If the Seller feels spurned by the earnout, it’s not too difficult for the Seller to find a lawyer who can devise claims that the Buyer violated the express terms of the contract or simply didn’t act in “good faith” in connection with the earnout.

Earnout litigation is particularly scary because (1) the dollars are usually big, (2) there is often a lot of gray area over how the earnout works in a particular set of circumstances, and (3) legal and accounting fees can be substantial, as it’s unlikely the Buyer will be successful in getting a judge to dismiss a claim at an early stage.

Oftentimes, parties try to head off the litigation risk by pre-appointing a neutral accountant to arbitrate any earnout disputes. While this may help to reduce the legal costs of an earnout dispute, it doesn’t provide much more certainty as to the outcome. In this case, it’s important to pre-select a well-known accounting firm who (1) has experience being an arbitrator and is capable of understanding and applying accounting, legal and business principles, (2) is independent of the parties and (3) can be trusted to make a rational, timely, and cost-efficient decision.

With all of these potential concerns, is there any hope for an earnout that’s workable? The short answer is yes, but careful attention needs to be given to the structure and terms of the earnout during the early planning stages of the transaction. It is critical to make every effort to spell out all of the key terms of the earnout, including:
  1. Basic economics of the earnout, including a detailed description of how the earnout is calculated and what factors are considered (or disregarded) in making the calculation;
  2. Any caps on the earnout amount that may be payable to the Seller, and whether those caps are calculated on a cumulative basis or annual basis;
  3. Duration of the earnout, including a description of what effect (if any) certain intervening events might have on the earnout (e.g., subsequent sale of the acquired company or Buyer, termination of the Seller’s employment [whether as a resignation, for cause/without cause, due to death or disability, etc.], change in the acquired company’s product offerings, combination of the acquired company with another business unit of the Buyer, etc.);
  4. How and when the earnout (or a partial installment of the earnout) may be forfeited by the Seller, and whether there’s any way for the Seller to earn back a forfeited earnout payment;
  5. When and how the earnout is paid, including a description of any approvals required from the Buyer’s financing sources as well as any possible security arrangements that may be provided to the Seller (e.g., mortgages or other liens on the Buyer’s assets) in order to secure payment of the earnout;
  6. What level of operational involvement, information, and/or approvals (if any) will be afforded to the Seller after the closing; and
  7. How disputes regarding the earnout will be settled.
Earnouts are probably the most difficult M+A concept to structure and implement as they require all parties to look into the crystal ball and anticipate issues that are both likely and unlikely. To exacerbate the issue, the intentions of the parties become less clear as time passes and circumstances change. We generally recommend Sellers to view earnouts as the “gravy.” If the Seller collects on the earnout, that’s a nice bonus, but the earnout shouldn’t be the primary motivation for doing the deal. However, Buyers should also be cognizant of the risks that earnouts raise for their continuing operation of the business after the closing. A good earnout strategy takes account of these risks and plans ahead for the anticipated potential risks – while building in as much flexibility as possible to address unexpected issues when they arise.

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