Uncertainty brought on by the virus abounds as of the time this article is being written in the middle of the summer of 2020, with a rise in COVID-19 cases in the South, Southwest, and Western United States. Buyers and sellers of businesses are less able to forecast the earnings and future performance of the target business as a result of the pandemic’s unpredictable effects. It is challenging to make predictions, especially about the future, as either Mark Twain or Yogi Berra allegedly said. ”.
Parties to M&A transactions are likely to use earnouts more frequently in the current environment. Earnouts can close the valuation gap between buyers and sellers for parties structuring a transaction to address future uncertainties brought on by the pandemic. A target business’s future risks and rewards are distributed through an earnout so that both parties benefit from a successful outcome and share the risk in the event that things do not go as planned. However, because they require the parties to project into the future, earnouts are inherently challenging to design and implement.
Earnouts are often half-jokingly referred to as “litigation magnets. The high stakes make disputes particularly ugly,[1] resulting in the need for extensive time and financial investment in the ensuing litigation. If a carefully thought-out earnout can prevent or make it possible for a dispute to be quickly settled, it is worth the upfront work.
In this article, a dispute management director at SRS Acquiom and two seasoned M&A attorneys share their perspectives. SRS Acquiom brings a wealth of expertise as it has participated in over 2,100 transactions as the seller representative or in a similar capacity. SRS Acquiom has witnessed first-hand when earnouts function as intended and when they turn into disputes that are challenging to resolve. From our combined experience, we will examine the intricate elements of a well-structured earnout in-depth and talk about some best practices for creating earnouts that reduce disputes.
Earnouts (Mergers and Acquisitions)
Advantages of earnouts
Earnouts can be advantageous to both a company’s buyer and seller. Advantages of earnouts for buyers include:
Advantages of earnouts for sellers include:
Earnouts must be structured properly and fairly in order to be advantageous to both parties.
What are earnouts?
Earnouts are payments a seller of a business only receives from the buyer if the company meets predetermined performance goals. In addition to paying a portion of the company’s value up front, the buyer may also pay the seller more money if the business is successful in the future.
Earnout payments are typically determined by buyers and sellers based on the company’s sales or earnings. If the company surpasses predetermined margins, the seller typically receives a percentage of sales or earnings. An owner might, for instance, sell their business for $750,000 million plus 4% of future sales.
Reasons buyers and sellers might agree to earnouts include:
In a sense, the seller is financing the buyer’s acquisition of the company. The more money the seller might make from the company’s success, and the quicker the buyer can repay their “loan,” the better. In a company sale contract, provisions are typically listed that describe earnouts and their specifics.
Disadvantages of earnouts
Depending on the company’s performance and the specifics of the contract, earnouts do have a few drawbacks. Potential disadvantages for buyers include:
Potential disadvantages for sellers include:
Earnout contracts are also intricate and must contain information about every term and condition. If poorly written, they may cause misunderstandings and confuse both the buyer and the seller. Considerations when structuring an earnout agreement include:
Earnout examples
Earnout contracts are made by buyers and sellers specifically for their companies’ size, type, and goals. Here are two examples of possible earnouts:
Example 1
A company’s sales are $70 million, and its earnings are $8 million. The company receives a $300 million offer from a buyer, but the seller feels it is worth $500 million. If you were to sell it for less, you might be underestimating its potential for growth.
They come to an understanding by accepting an earnout that permits the buyer to pay $300 million up front and an additional $200 million if sales reach $100 million within four years. Buyer only pays an additional $100 million if sales do not reach that amount in four years. The buyer does not pay an earnout if sales fall below $70 million within four years.
Example 2
A seller asks $75 million for their business, but a potential buyer can only afford $50 million. The seller offers to finance the remaining funds so the buyer can afford to buy the business because the company’s fair market value is $75 million. In essence, the seller lends the buyer $25 million, which the buyer must repay based on the company’s earnings over a specific period.
For a five-year “loan,” the seller establishes a minimum earnings percentage in order to achieve this. A minimum of 15% of earnings before interest, taxes, depreciation, and amortization (EBITDA), which cannot be less than $5 million, must be paid by the buyer in the first year. The buyer must contribute a minimum of 15% EBITDA in year two, which cannot be less than $10 million. Up until the buyer fully settles the purchase price of the company, the minimum increases annually.
This earnout strategy is based on the idea that the more successfully the company performs, the quicker the buyer can pay off the loan.
FAQ
What is meant by earn out?
A contractual clause known as an earnout states that the seller of a business will receive additional compensation in the future if the company meets certain financial objectives. These objectives are typically expressed as a percentage of gross sales or earnings.
What is an earn out payment?
When buyers and sellers want to close a deal but cannot agree on a price, they frequently use a tactic known as an “earn-out.” “An earn-out is a contingent payment made by the buyer to the seller only when certain performance goals are met.
What is an earn out in an acquisition?
An “earnout” is a legal provision in a merger or acquisition agreement that outlines potential future payments to shareholders of a seller by a company’s buyer. Earnouts are typically considered “earned” if the acquired company achieves specific financial or other milestones following the acquisition’s completion.
What is earn out in accounting?
In an earnout, a buyer will pay a target company’s initial purchase price up front, with potential future payments made contingent upon the achievement of specific performance metrics as specified in the purchase agreement.
