How does an earnout work in M&A?

An earnout is a popular tool often used in mergers and acquisitions. It’s a financial arrangement in which the seller of a business receives additional payments in the future based on the performance of the business after it has been sold. Typically, it is structured as a portion of the purchase price that is contingent on the achievement of certain financial targets or other performance metrics, and can be a useful tool to bridge any value gap between buyer and seller.

Benefits of using an earnout

Using an earnout can be beneficial for both the buyer and the seller. For the seller, it can provide additional compensation and help to ensure that the business continues to perform well after the sale. For the buyer, it can help to reduce the risk of overpaying for the business by tying a portion of the purchase price to future performance.

Both parties must first agree on the terms of the earnout, including the specific performance metrics that will be used to determine the additional payments. The period may vary depending on the nature of the business and the performance targets, but typically it’s between one and three years.

It is a useful tool that can provide both parties with numerous benefits. The parties have flexibility by negotiating a purchase price that considers the future performance of the business and also helps mitigate the risk for the buyer as a portion of the purchase price is tied to the business’s future performance.

As the seller’s payout is based on business performance, the seller will be more inclined to help improve the performance of the business by providing their expertise and knowledge.

The arrangement allows the buyer to conserve cash and fund the acquisition through future cash flows of the business and also helps the buyer validate the valuation of the business as they can test the assumptions behind the purchase price.

Disadvantages of using an earnout

Before choosing this option, both parties should consider the disadvantages of this route, including:

1. Uncertainty: It does not provide a seller with a clean break; the future performance of the acquired business can be difficult to predict, which can lead to uncertainty around the amount of money the seller will receive. Where a seller is to remain as an employee, buyers sometimes introduce “bad leaver” provisions under which a seller will forfeit their rights to any future earn out payments if their employment ends. These areas  can create risk for both parties.
2. Disagreements: if the buyer and the seller have different ideas about how the acquired business should be run, this can create conflicts, impacting the performance of the business and the earnout payment. Both sides will want to ensure that there can be no artificial manipulation of the performance of the business during the earn out.
3. Complexity: earnout agreements can be complex and time-consuming to negotiate and administer, which can add to the cost of the transaction and create additional work for both the buyer and the seller.
4. Legal issues: there can be legal issues surrounding earnout agreements, such as disputes over the calculation of earnings or the terms of the agreement. These disputes can be costly and time-consuming to resolve. It’s always good to engage accountants early on in the process to help structure the earn out and to advise on relevant accounting standards and policies.
5. Cultural issues: if the buyer and the seller have different cultures or values, this can create challenges in working together to achieve the earnout goals.
6. Short-term focus: earnout agreements typically focus on short-term performance rather than long-term growth, which may not align with the seller’s or the acquired business’s overall objectives.
7. Integration challenges: the process of integrating the acquired business with the buyer’s existing operations can be complex, which can impact the performance of the business and the earnout payment.

Using an earnout can be a useful tool for structuring a business sale, but it should be approached with caution and careful legal, tax and accounting planning to ensure that the arrangement is fair and beneficial for both parties.

If you have any questions before entering into an earnout agreement, please contact Lance Feaver.