Both the seller and the acquirer have interests that are aligned in a deal like this. The seller wants to cash out, while the acquirer earnout data from m&a deals wants to acquire the assets. Building on the example above, we’ll look at this deal from the buyer’s (Company B’s) perspective.
For example, if an earnout pays the seller 3% of revenue only if annual revenue exceeds $10 million, what should the amount be if the business generates revenue of $12 million in the first year, $20 million in the second year, and $8 million in the third year? Multi-year earnouts are negotiated on a deal-by-deal basis with no standard approach. Before deciding on the metric, it’s important to consider how the business will be run after the closing. Is the earnout being considered to mitigate risk or incentivize the seller? Understanding the dynamics of the transaction and the parties’ underlying motivations and concerns is a prerequisite to structuring an earnout. Preparing your business for sale, along with expert negotiating skills, can also prevent ‘retrading.’ Retrading is when the buyer attempts to renegotiate the purchase price at later stages in a transaction after an LOI has been signed and agreed upon.
The most common of these is how the target firm will be run en route to achieving the mutually agreed-upon targets. This challenge is most common where the acquired firm becomes part of a larger business and strategy and is thus expected to operate differently from how it did as a standalone entity. Though the scope of this article doesn’t extend as far as exploring litigation issues, contractual provisions should be put in place that protect buyers against potential litigation from sellers.
The earnout provisions may address whether the buyer will have an offset right in the event of indemnification claims against the seller. The seller will strenuously resist such a right and may insist on a specific statement disclaiming any offset rights. The seller will argue that the buyer should look solely to the buyer’s M&A reps and warranties insurance or the escrow indemnity established in the acquisition agreement for recourse on indemnification claims. When working with M&A advisors, it’s also important to understand when your advisors expect to be compensated based on the earnout. However, some advisors are willing to work with you to estimate the amount of the earnout and negotiate an early payment to minimize the administrative complexities of ongoing monitoring.
- An earnout means they pay less up front and therefore have to borrow less money at the higher interest rates.
- Fourth, we have the accounting assumptions that will be used to measure performance.
- Earnouts can be structured so that the amount paid is a lump sum (ie. $10 million), a percentage of revenue (ie. 5 percent of gross sales), or a percentage of earnings (ie. 10 percent of EBITDA).
- The earnout agreement should clearly specify how disputes regarding the earnout are handled.
- Often buyers and sellers agree on price; however, buyers perceive exogenous risks which could put downward pressure on the target firm’s performance and look to structure earnouts to shift the risk of underperformance to the seller.
Maybe the management team isn’t capable of growing the business as effectively as the founders that will be bought out with this transaction. An earnout is a contractual provision regarding how the buyer will pay the seller for the business they are buying. In an earnout, the buyer doesn’t pay the seller the full purchase price amount up front, instead they tie a portion of the purchase price to business targets. [1] Certain earnout structures often require a cap to the total payout. There may also be additional language clarifying whether indemnification claims offset earnout payments. And the second provision should stipulate that the buyer has absolute discretion over the operation of the target firm post-acquisition.
The Downside to Earnouts
Sectors that see a higher proportion of earnouts built into transactions include technology, healthcare, marketing and advertising. First, the total price to be paid for the acquisition can be based on the seller’s future performance rather than solely on the seller’s projected performance. An “earnout” is a contractual mechanism in a merger or acquisition agreement, which provides for contingent additional payments from a buyer of a company to the seller’s shareholders. Earnouts are typically “earned” if the business acquired meets certain financial or other milestones after the acquisition is closed.
Accounting Considerations for the Buyer and the Seller
Therefore, some acquirers will attempt to mitigate risk by offering alternative streams of revenue known as an earnouts. If Company A doesn’t hit $75 million in revenue within the next five years, then the seller will only receive the initial $50 million. Previously, Kip was a Director with the SRS Acquiom Transactional Group, where he collaborated with clients and counsel to negotiate M&A documents including purchase, escrow, payments, and other transactional agreements. Before joining SRS Acquiom, Kip was an attorney with a Denver-based boutique business law firm where he assisted clients with M&A transactions as well as general corporate governance and securities matters. Earnouts can smooth the passage of a deal towards completion and resolve a valuation gap when one presents itself. Parties should seek to base agreements on accurate and unambiguous documentation, and agree the cadence and timeline for earn out payments as a priority.
Structuring a portion of the purchase price as a seller note is best used when the buyer is concerned about the reps and warranties’ veracity in the purchase agreement and is not normally a suitable replacement for an earnout. The seller note would only have a right of offset based on the purchase agreement’s indemnification language. This normally would not address the financial performance of the business. Earnout terms vary widely from one deal to another and can becomplex to negotiate, structure and administer. When determiningwhether to agree to an earnout, it is essential for each party toassess the objectives of the deal and the likelihood of achievingthe earnout performance metrics.
The Ugly Business of Negotiation Deadlocks
And sellers in particular should be watchful for any unorthodox application of accounting principles so that (for instance) the business’s earnings for a given financial period miss the agreed milestone for earnout payments. It may be advisable for the SPA to explicitly stipulate adherence to generally accepted accounting principles (GAAP) methods, or international financial reporting standards (IFRS), to mitigate risk here. If the perceived risk is high, then either a buyer will offer a lower purchase price or seek to mitigate the risk through transaction structuring, such as earnouts or stronger reps and warranties. It’s critical that your advisor understands your business from an operational standpoint so they can see how the deal mechanisms a buyer proposes fit into the overall deal structure. Consulting agreements are similar to employment bonuses, but they are often designed to facilitate the business’s transition from the seller to the buyer. In most consulting agreements we see, the seller agrees to help the buyer on an ad-hoc basis at a flat hourly fee and is available anytime by phone or email to assist with detailed transition matters.
Earnouts are payments to the target that are contingent on satisfying post-deal milestones, most commonly the target achieving certain revenue and EBITDA targets. Earnouts can also be structured around the achievement of non-financial milestones, such as winning FDA approval or winning new customers. An earnout, formally called a contingent consideration, is a mechanism used in M&A whereby, in addition to an upfront payment, future payments are promised to the seller upon the achievement of specific milestones (i.e. achieving specific EBITDA targets). The purpose of the earnout is to bridge the valuation gap between what a target seeks in total consideration and what a buyer is willing to pay.
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Posture can also be maintained through an even disposition throughout all discussions and negotiations with the buyer. Regardless of the law, it’s critical that an efficient system exists for resolving disputes. Earnouts are unpopular in countries with relatively lax enforcement of contracts.
They see that a potential deal would give them access to a new market and give Company B the opportunity to upsell Company A’s existing customers Company B’s higher-priced consulting services. Additionally, as an older, long-established business they see this M&A transaction as a way to eliminate a high-growth competitor that is partially disrupting the space with a unique offer. First, the earnout recipients are the ones that get paid if the conditions of the earnout are met. Earnouts can also include considerations for other key executives if structured that way. Earnouts are primarily used in instances where a privately held company is being purchased.
