We frequently see earnouts in the business acquisitions we oversee. An earnout can be a useful tool when parties cannot agree on the value of the target company.
When an earnout is used, a portion of the purchase price is made contingent on the achievement of specific financial or operational targets in the future. This means that, at the time of sale, the seller only receives a portion of the purchase price and the remainder is deferred until, and if, the agreed-upon targets are met. If the targets are not met, the seller does not receive this portion of the payment.
In practice, earnouts often lead to disputes, both before and after the transaction is closed.
What are the key considerations for setting up an earnout arrangement?
Conditions
It is important to clearly define in the sale and purchase agreement the conditions and additional rules under which the earnout will be paid. Consider in this regard the following aspects:
1. What exactly is the earnout contingent on? Is it based on the gross margin, operating profit, or another metric?
2. What thresholds need to be met to trigger the earnout?
3. How is the earnout calculated?
Tips:
a. Establish clear calculation principles (e.g. consistency with the latest financial statements).
b. Define any applicable normalizations; and
c. Append an earnout calculation model to the sale and purchase agreement.
4. How long is the earnout period?
5. Is there a minimum/maximum earnout amount (e.g. could it become negative, requiring the seller to refund part of the purchase price already received)?
6. When should the earnout be paid?
7. Is the buyer required to provide security for the earnout payment?
8. Can the buyer offset claims against the seller using the earnout?
Seller protection
After the acquisition date, the seller often loses control over the target company. This makes the seller dependent on the buyer to achieve the earnout targets.
Given this risk, it is crucial for the seller to include appropriate protective measures in the sale and purchase agreement. These could include:
1. Acknowledgment by the buyer that maximizing the earnout is a key factor for the seller in entering into the sale and purchase agreement; and
2. Buyer obligations, ensuring that:
- The target company’s operations continue in a normal and prudent manner, consistent with pre-acquisition policies;
- The cost structure of the target company is not increased without the seller’s consent;
- No business units of the target company are discontinued or sold; and
- No revenues or employees are transferred to an affiliated entity.
However, it is important to note that, in practice, it is often difficult to negotiate a fully seller-friendly protection structure. Buyers typically want sufficient flexibility to run the business without excessive restrictions.
Information rights
It is also crucial for the seller to ensure they have access to sufficient information about the operations of the target company. Without adequate information, it becomes difficult to assess or prove whether the buyer has complied with the agreed-upon protective measures. To address this matter, the sale and purchase agreement should include an information rights clause (such as periodic updates on the target company’s performance and the right to inspect the target company’s records upon reasonable request).
Dispute resolution
Earnouts are often a source of post-closing dispute. To avoid lengthy litigation in regular courts over an earnout dispute - where judges may lack expertise in the key parameters of the earnout and court rulings are typically public - we recommend including a specific dispute resolution mechanism in the sale and purchase agreement.
Such a mechanism typically stipulates that if a dispute arises over the earnout determination, the dispute will be referred to a binding advisor or arbitrator with relevant expertise, such as an independent certified accountant. The advantage of this approach is that the procedure is faster, and the ruling can be kept confidential.
In summary, it is essential to seek proper legal advice when entering into an earnout arrangement to minimize the risk of disputes down the line.
In the next blog post, we will discuss W&I insurance, which we are increasingly encountering in business acquisitions.
