News flash: Sometimes, buyers and sellers can’t agree on the value of a company.
The seller is interested in getting the highest possible price, of course, while the buyer might be apprehensive about the company’s ability to grow as promised or keep customers and key employees.
Enter the earnout.
An earnout is a useful means of bridging a valuation gap and getting a deal done. It’s a financial arrangement in which the buyer agrees to pay the seller a predetermined amount if certain targets are met post-closing.
In the complex world of buying and selling a business, coming to an agreement on the proper price for a business can be difficult. An earnout is a common tool used in many transaction structures.
This article will educate you about what an earnout is, how it can fit into the sale of a business, and the many factors and concerns that both buyers and sellers need to understand about earnouts. We will discuss the general purposes, advantages, and challenges of an earnout, the key elements of an earnout, the legal and tax implications involved, and how deal structures may be put together.
An earnout is a form of deferred payment to the seller that is contingent on certain events occurring post-closing in a manner that depends on the performance of the acquired company. An earnout can be tied to revenue, EBITDA, or a non-financial metric such as retention of key employees or the issuance of a patent.
Earnouts are rare in smaller transactions but common in mid-market deals. In some circumstances, as you’ll see below, an earnout can be tied to as much as 25% of the purchase price.
To receive an earnout, the seller must meet or exceed specific targets or milestones. These can include financial thresholds for revenue, gross margins, or net profit. They can also include non-financial thresholds such as market acceptance, technical achievements, or regulatory approvals within a specified period, usually one to five years after closing. A good earnout formula is easily defined, measured, objective, and not capable of being manipulated by either party.
Earnouts generally fall into one of two camps. The primary difference between the two is the underlying motivation of the buyer which can be distinguished as follows:
Earnouts offer the following benefits:
While earnouts can be seductive due to their ability to bridge price gaps and create alignment, earnouts are loaded with potential problems. Earnouts are commonly negotiated but rarely signed.
For smaller transactions, it’s common to mention the possibility of an earnout at the outset. However, the parties usually drop the idea of an earnout once they understand the true complexity of properly drafting an earnout. Due to this complexity, earnouts are primarily used by financial buyers, less commonly used by corporate buyers, and rarely used by individual buyers.
The concept of an earnout is simple, but properly creating and drafting an earnout is difficult — they are complex, hard to manage, and often lead to conflict and disagreement. It’s rare to find an earnout that isn’t debated, argued, or eventually litigated. Earnouts are susceptible to different interpretations and sometimes to subconscious manipulation by the parties. While they can enable parties to agree now, unless properly drafted, they simply convert today’s agreement into tomorrow’s dispute.
An M&A advisor should provide a preliminary valuation that includes a range of potential values, possible deal structures, an analysis of the cash proceeds, tax implications, and an assessment of risk factors in a business that may lead to an earnout.
Earnouts are designed primarily to mitigate risks or to incentivize the seller. Earnouts proposed to mitigate risks can often be anticipated. Earnouts designed to incentivize the seller to continue operating the business can’t be predicted, however, and because they are an incentive, they should not cut into the potential value of the company.
With a preliminary valuation in hand, the seller can determine to what extent an earnout is reasonable, putting them in a position to respond quickly to proposed deal structures that include an earnout. Remember that valuation is a range concept, and an earnout can only be anticipated to a certain degree. Strategies designed to bridge price gaps come in many forms, and an earnout is just one of many devices that can be used.
Once a buyer proposes an earnout, the seller should determine the probability of achieving the targets, therefore, receiving the earnout payments. Generally speaking, the probability of meeting targets is highest in the first year and decreases with each passing year.
Because the seller can’t accurately predict what they will receive, an earnout’s present-day value is difficult to measure. Due to this uncertainty, using discounted cash flow techniques can result in an extremely low value due to the discount rate required to account for the risk associated with the earnout. This makes it difficult to compare two earnouts on a financial basis or to use formulas in a spreadsheet. The overall deal structure and its components, such as earnouts, are some of the many factors to consider with a letter of intent (LOI). When an earnout is proposed, the seller should determine to what extent they are dependent on the earnout and to what extent the earnout is frosting on the cake or simply a bonus.
Earnouts are documented at two stages in the transaction:
Letter of Intent (LOI): When buyers initially assess a business, they often visualize a deal structure that addresses the risks and opportunities inherent in the business. They may perceive the business to have an excessive amount of risk and consider an earnout as a primary element of the purchase price.
A mistake commonly made by sellers is to accept a vague earnout in the LOI, such as “The purchase price will include an earnout that will pay the seller up to an additional $5 million in the purchase price, with targets to be negotiated and agreed upon during the due diligence period.” It’s critical to be as specific as possible in the language of the earnout. The key elements of the earnout should be clearly defined and documented, including the size of the earnout, measurement metrics, thresholds, who controls the business, when and how payments are made, and so forth.
The seller has the most negotiating leverage prior to accepting an offer and should use this leverage to their advantage. Agreeing to vague terms or restrictive elements in the LOI, such as a long exclusivity period, will result in a loss of leverage for the seller. The more issues the buyer uncovers during due diligence, the less attractive the deal will be with time. Slowly, the buyer will start hacking away at the purchase price and increasing the protective elements of the transaction. For this reason, the seller should spend as much time as possible clarifying the earnout and other key elements of the transaction before accepting an LOI.
Purchase Agreement: The parties (typically, the buyer’s counsel) begin preparing the purchase agreement and earnout agreement during the due diligence period. It’s critical that an attorney and CPA experienced in M&A transactions are involved in the process. A small mistake in the language of the earnout can cost hundreds of thousands of dollars.
Economy: Earnouts are more common in a buyer’s market. In a seller’s market, sellers can often demand a higher purchase price with no earnout, especially if the business is properly marketed with multiple buyers competing to buy the business and if there are no major uncertainties in the business. On the other hand, deal structures are more restrictive in a buyer’s market. For example, deals may include more stringent representations and warranties, lower baskets, longer indemnity survival periods, larger escrows, and larger earnouts. This is partly because a seller may have fewer choices in a down economy, and the buyer may be assuming more risk in a less-than-favorable market. In this scenario, the buyer may attempt to offset the risk by shifting some of it to the seller.
Industry: Earnouts are used more frequently in some industries than others. For example, earnouts are common in professional service firms — healthcare, law, accounting, and the like — due to the sensitive nature of retaining clients and employees. A substantial portion of the purchase price may be structured as an earnout that is dependent on the retention of clients or employees. Pharmaceutical and other businesses that face product risks, such as those dependent on the issuance of patents or FDA approval, also commonly tend to have earnouts as a component of the purchase price.
Earnouts can also be common in high-tech transactions to bridge price gaps. Tech businesses may be growing at a steady pace — sometimes as much as 50% to 100% annually — meaning a buyer may be willing to pay a high price for the business, but only if the growth rate continues. An earnout is the only sensible tool to account for this uncertainty, other than reducing the purchase price or paying the seller with stock in the surviving entity. Earnouts are also common in service-based companies if the retention of customers or employees is a concern. Earnouts can also be used when the parties come from different industries and the buyer has difficulty accurately gauging the risks associated with the business and the industry.
Size: Earnouts are more common in the middle market and for large publicly traded companies. In the sale of public companies, the buyer often pays the target (the seller) with the buyer’s stock. This serves a similar purpose to an earnout because the seller has an equity interest in the surviving entity. This is known as a Type B reorganization and has the primary benefit of being tax-deferred for both the buyer and the seller. Earnouts are much more commonly used in the middle market for the following reasons:
Integration: Unfortunately, earnouts are most common in companies that will remain as stand-alone businesses after the closing, with little integration between the acquirer and the target. This is unfortunate because this precludes the seller from being paid for synergies. Without integration, there will be fewer synergies, meaning the buyer is likely to pay less for the company.
Corporate Governance: Interestingly, some have opined that Republican CEOs, who are often viewed as more conservative than Democrat CEOs, are less likely to make acquisitions than their counterparts. If they do make acquisitions, they are more likely to pursue companies in the same industry with significant financial and operating information. They are more likely to use cash and less likely to use earnouts in the deal structure based on their opinions.
Most deal structures will combine various elements, such as cash, debt, earnouts, consulting agreements, employment agreements, escrows, holdbacks, and so forth. It’s important to understand how earnouts fit into the overall deal structure before considering their validity. When assessing the attractiveness of an offer, all elements of the transaction should be broken into contingent (such as earnouts) and non-contingent components.
Most middle-market transactions tend to be composed of three primary components: cash, earnouts, and escrow. Cash usually represents between 70% and 80% of the transaction value, while earnouts and escrows account for the remaining 20% to 30% of the purchase price, although earnouts can be as high as 75% of the purchase price. Ideally, the seller should receive cash at closing based on the company’s current value, less the amount of earnouts designed to mitigate significant and uncertain risks. The balance of payment should be in the form of an earnout designed to incentivize the seller if they will be operating the business after the closing.
What role do earnouts play in an overall deal structure? Here are some common guidelines regarding the primary components of the purchase price…
Small Transactions: $5 Million or less in Purchase Price
Here are a few samples of common deal structures we encounter for smaller transactions:
Mid-Sized Transactions: $5-$50 Million in Purchase Price
Following are a few samples of common deal structures we encounter for middle-market transactions:
The following are the general, high-level objectives of using an earnout that can apply to all M&A transactions:
Bridge Valuation Gaps: Earnouts are commonly used to resolve opinions regarding a business’s value, such as when the seller feels the business has significant potential that is likely to be realized in the near future. When M&A markets are hot, high prices can often only be justified with the inclusion of an earnout as a fundamental component of the purchase price. Earnouts bridge the price a buyer may be willing to pay based on the seller’s outlook of the business versus a value based on current financial performance. Contingent payments, such as earnouts, enable the parties to allocate the risk of future performance — they reward the seller if certain objectives are met while minimizing the buyer’s risk if the objectives are not met.
Address Uncertainty: Without an earnout, the only way to address uncertainty is through a reduced purchase price. Risk and reward are highly correlated. If the risk is higher, then the reward must be lowered to account for the increased risk. By reducing the risk of uncertainty for the buyer, the seller can achieve a higher reward. No other mechanism creates this dynamic. For example, if the business appears to have a solid growth opportunity ahead, an earnout allows the seller to get paid if this growth opportunity is realized.
Align Interests: Earnouts are a powerful tool for aligning interests between buyer and seller — they are commonly used as an incentive to motivate the seller to stay on board and continue operating the business post-closing. The seller must be incentivized if they remain to operate the business, which is common if the buyer is a financial buyer. Earnouts also address information asymmetries — the seller knows much more about the business than the buyer and has a greater degree of influence on the business if they remain as CEO. Earnouts can provide the buyer comfort that the seller will stay to facilitate a smooth transition. Earnout agreements can also be used to retain and motivate key target firm managers.
Mitigate Risk: By reducing uncertainty, earnouts reduce risk for the buyer. For example, risk is reduced for the buyer if a portion of the purchase price is held back until key customers have successfully been transitioned, litigation has been settled, or FDA approval has been obtained. An earnout helps prevent a buyer from overpaying if they are unclear about the future value of the business. With an earnout, the buyer is less likely to overpay. By holding back a portion of the purchase price, the buyer’s risk is reduced. It’s this risk reduction that enables the buyer to pay a higher purchase price.
Align Timing: “I want to sell my company after the next big sale.” We have all said it before. What’s the solution? Sell the company now but include an earnout that compensates the seller on ‘that next big sale.’ In many cases, there is an increased chance of closing the next deal if the company now has a larger competitor’s support, name, or reputation.
The following are specific objectives of using an earnout that can apply to a particular M&A transaction:
Addressing General Transactional Risks & Deal Structure
This is normally only recommended if no other buyers are willing to purchase the business. Caution should be used when considering the sale of a business via an earnout to family members. This situation can place incredible stress on the buyer if the seller’s retirement is dependent on the business’s continued success. The seller’s retirement may depend on decisions made by their children, and the seller may feel an overwhelming desire to control a business they were accustomed to running for decades. Such a situation and pressure can strain relationships and should be cautiously considered.
Earnouts should not be used solely to insulate the buyer from the general external risks of operating a business. While earnouts are often used to minimize uncertainty, they should not be designed to protect the buyer from general economic and market-related risks. There are risks in any business, and the new owner should be solely responsible for absorbing the outcomes of these risks. Care should be taken during negotiations to ensure that earnouts are properly used and do not transfer the general risks of operating the business to the seller after closing. Unfortunately, there is no clear line here.
If a business that generates $2 million in EBITDA has a baseline value (with no risks of uncertainty) of $10 million at a 5.0 multiple, then the seller should not accept an offer with an earnout that values the company at a baseline 3.0 multiple ($6 million) and offers the seller the potential to earn $4 million via an earnout. If, on the other hand, that same business is about to land a large customer that will increase revenue by 25%, it may be appropriate to structure a portion of the purchase price as an earnout contingent on obtaining the new customer. In this case, the baseline value should be $10 million, and an earnout could be structured based on the acquisition of the new customer.
Earnouts should be primarily used to address uncertainty and situations in which the seller is willing to bear the risk of that uncertainty. If there is no specific uncertainty in the business (customer, employee, product risk) beyond general economic and market conditions, then an earnout is unlikely to be reasonable.
Earnouts should also not be used to defer a company’s valuation to a later point in time. While earnouts can bridge valuation gaps, the parties should not avoid discussions regarding the purchase price when negotiating the letter of intent. While this is common for risk-averse novice buyers, this is less common for experienced buyers, such as PE firms. It is common for unsophisticated buyers to propose a vague earnout in a letter of intent because they are either risk-averse or unwilling to decide what the company is truly worth to them. In essence, they are deferring their decision to a later time, and if left unchecked, this will certainly lead to killing the deal at a later stage.
The following is a list of prerequisites that should be present before the parties consider an earnout.
Cash at Closing: The seller should receive enough cash at closing, excluding the earnout, to be satisfied. In other words, the seller should ideally be prepared, in most circumstances, to not receive any amounts due in the earnout agreement. The seller should not be highly dependent on receiving the earnout, whether financially or emotionally, especially if the certainty of receiving the earnout is low. It’s best to treat the earnout as a bonus instead of a critical component of the purchase price. Earnouts are used to mitigate uncertainty, and the seller should be emotionally prepared to accept the uncertain nature of receiving the earnout.
Trust & Confidence in the Buyer: Earnouts are subject to interpretation and manipulation by either party – it’s paramount that the parties trust one another. Absent trust, close monitoring will be required by the seller to ensure the buyer does not manipulate the earnout. Even with close monitoring, the earnout can be manipulated, and the seller’s only recourse in these situations is to pursue the dispute resolution options outlined in the purchase agreement. Disputes are common in earnouts — and trust, not the law, is the most powerful prevention. Even the most carefully drafted earnout doesn’t guarantee a painless transaction. Most earnouts lead to disputes, but disputes can be quickly and efficiently resolved if the parties maintain a fair and trusting relationship. Absent trust, the disputes will turn costly and consume enormous amounts of time and money.
If the seller is retiring and values their peace of mind, then trust with the buyer is even more important. The last thing a retiring seller may want to deal with is a toxic relationship with the potential for litigation that may drag on for years. Ironically, trust is the most powerful weapon for preventing earnouts. Buyers often propose earnouts because they lack trust in the seller. As a seller or a buyer, you must present yourself as a level-headed, trustworthy individual in all interactions. Never lose your cool. Never. Ever. Losing your temper, even once, can spell doom for the transaction structure.
The key to developing trust is honesty. When selling a business, truth is the safest lie. Buyers will conduct painstakingly meticulous due diligence that is bound to uncover the most infinitesimal of inconsistencies. If a buyer discovers the seller has been anything but forthright, they will likely pile on the protections — in the form of earnouts, escrows, and reps and warranties. A once attractive deal will instantly erode. The buyer will construct numerous provisions to minimize the impact of any additional untruths and their attendant risk — that is, if they don’t walk away entirely. If the buyer believes the seller to be a straight-laced, conscientious, reliable individual, they are more likely to propose a conservative deal structure with more cash down at closing.
Trust is also important in situations where the buyer will control operations after the closing. The seller must trust the buyer’s skills and abilities to manage the business post-closing properly. The seller must also trust the buyer’s strategy or be willing to let go entirely. Many entrepreneurs, however, find it difficult to let go after being at the helm for decades. Trust is likewise important in rollups, in which the seller’s upside will depend on the buyer’s ability to execute their strategy. If the buyer lacks the key skills required to operate the business deftly, the seller could scare off key customers or employees. These errors can have a major impact on the earnout payments.
If the buyer proposes an earnout, it’s critical that due diligence be mutual — in other words, the seller should also perform due diligence on the buyer — both operationally and financially. Soft skills such as communication and management skills need to be assessed if there is to be a continuing relationship after the closing, just as in any long-term relationship. If the buyer has completed other acquisitions, the seller can ask to speak with the past owners of acquired companies. Such a request is reasonable and often granted.
Control: Disputes regarding control are common. Whoever has control of the business possesses the ability to manipulate the earnout. If the seller oversees operating the business post-closing, then the seller should have a meaningful amount of control over the business’s operations. If the buyer has control, the buyer will have the ability to hold down earnings to minimize the earnout amount. If the buyer owns another company, this can be effortlessly accomplished by moving revenues or expenses between the two companies. Top-line metrics, such as revenue, are more difficult to manipulate than metrics lower on the P&L, such as EBITDA. An earnout based on EBITDA is much more easily manipulated than revenue, but all earnouts are subject to manipulation. Control is, therefore, a critical component of any earnout agreement.
The parties often address the issue of control by including language in the earnout agreement that requires the party operating the business to do so in a specific manner. For example, the agreement may require the buyer ‘to operate the business in a manner to maximize the amount of the earnout’ or to ‘not operate the business in a way to intentionally minimize the amount of the earnout.’ Such broad language is best suited when a party has a wide array of weapons available to manipulate the earnout.
Stand-Alone (Minimal Synergies): One of the chief disadvantages of earnouts is their inability to facilitate integration. When the target becomes integrated into the parent company, measuring the earnout becomes difficult, if not impossible. Earnouts are most commonly used when the business remains as an independent business or as a sovereign subsidiary of the buyer when existing management remains in place.
As a result, earnouts are either reserved for businesses that will remain stand-alone businesses post-closing or for situations in which the earnout can be objectively measured. Examples include:
Broad-based financial metrics, such as revenue or EBITDA, are difficult to monitor if two businesses will be integrated.
If synergies are likely to be achieved between the target and acquirer, a common alternative is a stock-for-stock transaction structure. However, these are usually only attractive for the seller if the acquirer is publicly traded and has a liquid market for their shares. Such a structure is attractive to the buyer because they can use their equity as currency to pay for the transaction, and it creates a strong alignment between the buyer and seller.
Motivation: If the owner remains with the business, they should be sufficiently motivated. If the seller is burned out, then it may not be wise to consider an earnout unless the business is not dependent on the owner’s personal efforts. Some buyers may become cautious if the seller tells them they are selling because they are burned out. A buyer may rightfully become concerned that the seller will disappear after the sale and want nothing to do with the business after the closing occurs. It’s wise for the seller to downplay the extent of their burnout. Buyers can also become concerned if a seller does not appear to be sufficiently motivated to receive the money they can potentially earn in the earnout agreement. They often reason that the seller has crunched the numbers and accounted for the risk of losing the earnout. It’s wise for a seller to demonstrably express an eager intent in executing the strategic plan necessary to receive the full amount of the earnout.
Location: International or cross-border transactions can materially impact the structure of earnouts. While international law is commonly merged with US law when it comes to international transactions, acquisitions of domestic companies can have legal implications if the target has substantial foreign operations. If a foreign buyer is purchasing a US-based company, the transaction is customarily handled by US attorneys, and the seller’s attorney does not need to have specialized knowledge of international law. If a US-based company is acquiring a foreign company, foreign legal counsel is advised. However, these transactions are commonly handled and documented comparably to US-based transactions. The legal concepts are similar, but nuances may exist that need to be addressed.
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. In most international transactions, it’s common to choose a neutral location for the ‘choice of law’ provision to discourage disputes. These distinctions can also have a bearing on the earnout. For example, a neutral ‘choice of law’ provision can discourage the seller from disputing the earnout and encourage the buyer to ‘push the limits,’ knowing that the seller is disincentivized to litigate.
Presale Preparation
As a seller, one of the best methods for preventing an earnout is to prepare your business for sale well in advance. For example, during our business assessment, we identified potential major risk factors that could lead to an earnout as a component of the transaction structure. If you minimize risks that a buyer is likely to see in your business, it’s far less likely a buyer will propose an earnout in the first place. The lower the overall confidence level a buyer has in your business, the more likely they will propose an earnout. One of the most critical areas is the degree to which the business is dependent on the owner. If the buyer considers the business to be highly dependent on the owner — with the owner having close personal relationships with the employees and customers, and the business’s identity is tied closely to the owner — the buyer will consider this excessively risky and counter the risk through a low purchase price or an earnout. If the owner has developed a strong management team, and the business does not depend on the owner, the seller will receive more cash at closing.
Most earnouts are proposed due to major risks in the business or uncertainty. Both can be mitigated to some extent in advance of the sale. Even if you don’t plan to sell your business in the near future, it’s still sensible to minimize your business risks from an operational standpoint. Mitigating risks will reduce the possibility of an earnout and likely increase the value of your business. Value is simply an element of potential return and risk. The lower the risk, the higher the value.
Presale Due Diligence
Presale due diligence is conducted before you begin the sale process. Presale due diligence mimics the due diligence a buyer will perform and is designed to uncover issues a buyer is likely to uncover. By performing your own due diligence in advance, you will be able to identify and minimize risks before you put your business on the market. While a buyer may not have proposed an earnout in their letter of intent (LOI), if they uncover material issues during due diligence that represent increased transactional risks, they will attempt to reduce this risk by either reducing the purchase price or proposing an earnout. Yes, it’s common for buyers to propose earnouts in the later stages of the deal if they uncover problems that were not initially disclosed. The only antidote to this is to retain a third party — such as an accountant, attorney, or M&A advisor — to perform presale due diligence and then address the problems you uncover.
Negotiating Posture & Momentum
Aside from presale due diligence, the next best tools in your arsenal for preventing earnouts are a strong negotiating position and negotiating skills. Your negotiating posture comes from having many buyers to negotiate with and not ‘having’ to sell. Posture can also be maintained through an even disposition throughout all discussions and negotiations with the buyer. Honesty and trust go a long way toward preventing an earnout.
Setting expectations with buyers is also critical and is best done through a third-party intermediary, such as an M&A advisor. Many buyers will feel the seller out to detect the likelihood of renegotiating at later stages in the deal. You need to set expectations when the LOI is accepted that renegotiating after an offer is accepted is not an option.
Momentum is also critical during the process. Many buyers intentionally slow down the process in an attempt to wear down the seller. Several months of negotiations and the obligation to exclusively negotiate with the buyer puts many sellers in a weak position. As a result, sellers are likely to cave into last-minute tinkering.
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. This renegotiation usually occurs during the tail end of the due diligence period. During due diligence, unscrupulous buyers will search every nook and cranny of the business for any flaw they can find. They then use these flaws as negotiating leverage for a price decrease. They may overreact to the bad news and tell you how distraught they are. But then they’ll let you know that they might be willing to move forward if you are willing to lower the price or restructure a portion of the consideration as an earnout. By preparing your business for sale, you minimize the number of flaws a buyer may discover during due diligence that they can use as leverage. And maintaining your negotiating posture sends buyers the subtle message that you aren’t susceptible to such ploys.
As a seller, it’s critical to understand the role of due diligence and be prepared for the thoroughness of the process. You must understand that every buyer will perform meticulous due diligence. You should be emotionally prepared to survive this painstaking period and not take personal offense at a buyer’s request. Buyers will become nervous if they overreact or become secretive and will be more likely to structure part of the purchase price as contingent payments, such as earnouts.
Earnouts are not a magic bullet. They are not suitable for all transactions. Earnouts should primarily be used to bridge price gaps, mitigate risks, and incentivize the seller. If the seller and buyer cannot agree on a price, they should determine the reason for the price gap. Once the cause is determined, the parties can decide which mechanism is appropriate to bridge the gap or address the buyer’s concerns. First, start by evaluating the parties’ objectives, and then decide what deal structure is most appropriate to meet those objectives. Generally speaking, buyers want to ensure sellers have as much skin in the game as possible. In most cases, several of these tools are used collectively to mitigate the risk and keep the seller on the hook.
Equity
Granting equity is most appropriate if the seller will remain in the business long-term and will retain control. Technically, equity is not normally granted but instead is rolled over. In other words, the buyer may only purchase 70% of the seller’s shares, for example, and the seller retains a 30% interest. Long-term earnouts of five years or more should probably be replaced with equity incentives. The primary advantage of equity as an alternative to earnouts is that it does a better job of aligning incentives and can be used as a long-term strategy for 5, 10, or 20 years. Equity incentivizes the seller to think both short-term (profits can be taken out as distributions) and long-term (growth in the value of the business). The parties should also consider how the seller will eventually liquidate their shares.
In most cases, this will happen through another exit in the future. It’s paramount that the parties draft bylaws and/or a shareholders’ agreement and a buy/sell agreement.
Employment Bonuses
Employment bonuses are similar to earnouts. However, they are more suitable when the seller plays a more defined role in the business, such as remaining involved in marketing. Earnouts tend to be based on high-level metrics for the business, such as revenue and EBITDA, while employment bonuses incentivize the seller in more discrete areas of the business. This would be more appropriate if the seller does not wish to play a management role in the business after closing but instead prefers to play a more defined role in the absence of management duties.
Consulting Agreement
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. This is most fitting when the buyer wants to ensure the seller will be available to help long-term with the transition but where the seller lacks control or influence over the performance of the business. The primary disadvantage of employment and consulting agreements is that they are tax-inefficient to the seller. Any payments are taxed at ordinary income tax rates, but payments are deductible to the buyer.
Escrows & Holdbacks
With an escrow, the parties appoint an independent third-party escrow agent to hold a portion of the purchase price, usually 10%-25%, to satisfy post-closing indemnification claims. This amount is normally held in escrow for a period of 12 to 24 months, called the ‘survival period.’ The money is governed by an escrow agreement and is normally only released upon the buyer and seller’s mutual agreement. The escrow agreement defines when the funds are released and the method for handling disputes. Most disputes are made in the last few weeks before the escrow period expires. Escrows are tied to the representations and warranties in the purchase agreement. They are used to ensure the buyer can easily recover damages if the seller has committed fraud, made material misrepresentations, or otherwise made an inaccurate representation regarding the business. An earnout can also be combined with an escrow, with the earnout payments held in escrow until the payment is made. This would assure the seller that cash is available to pay the earnout when it is due. Earnouts can also be used in lieu of escrow, and indemnification claims can be deducted from earnout payments.
Representations & Warranties (R&W)
Reps and warranties constitute about half of the content in a typical middle-market M&A purchase agreement. Representations are statements of past or existing facts, and warranties are promises that facts will be true. Reps and warranties force the seller to make key disclosures regarding the business before signing the purchase agreement. If any representations and warranties prove to be untrue or are breached — in other words, if the seller knowingly or unknowingly lied to the buyer — the buyer has a right to indemnification. Reps and warranties are strongly debated in most transactions and often include minimums, maximums, and other mechanisms that trigger when an indemnification claim can be filed. For example, if a minimum (usually called a floor) is $25,000, the buyer may not file an indemnification claim if the claim is less than $25,000. Reps and warranties are fundamentally a method for allocating risk between the buyer and seller. If the buyer is concerned about certain specific risks in the business, it may be possible to address the buyer’s risks through strongly worded representations and warranties regarding the business instead of an earnout. The R&W can then be funded with an escrow.
Type B Reorganization
A Type B reorganization is a stock-for-stock exchange in which the buyer pays for, or ‘exchanges,’ the seller’s shares with stock in its own company. Put simply, the seller and buyer are exchanging shares. The seller receives stock in the buyer’s company — and the buyer receives stock in the seller’s company. The target (seller) remains as a stand-alone subsidiary of the buyer. This is most practical when the seller is a publicly traded firm with a ready market for their shares or the seller does not require liquidity now and sees a strategic advantage in merging with the buyer. If the stock is not readily traded, the seller will now hold illiquid shares and have difficulty cashing out the investment. Regardless, in most cases, the seller has restrictions regarding when they can sell the shares and may argue for ‘registration rights,’ which enhances the seller’s ability to sell the stock. A Type B reorganization’s primary advantage is that it is tax-deferred since the seller will not pay taxes until the new shares are sold.
Seller Financing
Instead of structuring part of the purchase price as an earnout, the parties can structure it as a seller note (promissory note). The advantage of a seller note is the ability to offset the note against indemnity claims, otherwise known as a ‘right of offset.’ This right gives the buyer the ability to deduct amounts due under the seller’s note for any indemnification claims. The seller could then argue that an escrow or holdback is not needed due to the right of offset in the seller’s note. The parties can also include negative covenants in the note that reduce the payments if the business performs poorly. However, these are rarely seen. 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.
Royalties & Licensing Fees
Royalties and licensing fees are most applicable if tied to product sales and are commonly used if the seller has a product in development that is expected to be launched shortly but for which the revenue is difficult to predict. They may also be used when the seller has numerous other products in development, either owned by the company or independently. I recently encountered this situation with an online retailer of proprietary automotive parts. A full 90% of the revenue was generated from one product line, but the seller had a second product line in development that was expected to comprise approximately 30%-40% of the revenue once the line was launched. We discussed cordoning off the product line into a separate company. However, doing so would have proven to be too difficult, so we decided that a royalty or licensing fee would be the most practical approach.
Clawbacks or Reverse Earnout
A clawback is simply a reverse earnout. Money is given to the seller at closing and then ‘clawed back’ if the targets are not met. Instead of withholding a portion of the purchase price, the seller receives the entire amount and must then reimburse the buyer if the goals outlined in the agreement are not met. Clawbacks are not popular with buyers or sellers — buyers don’t want to chase a seller down to get their money back, and sellers don’t want to give back money they have likely already spent. Clawbacks are most common when money is provided to a business for expansion purposes, and the business owner has not used the funds.
Earnouts are usually limited to 10%-25% of the purchase price. A larger earnout may be applicable in unique circumstances, such as:
The primary element of an earnout is the formula on which it is based. Regardless of what metric is used, it will still be subject to manipulation and interpretation by the parties. But the more clearly objective and defined the target is, the less the metric will be subject to manipulation. Ideally, the metric can be independently confirmed by a third party.
Before deciding on the metric, it’s important to consider how the business will be run after the closing. Will the buyer or the seller be in control of the business? Will the business be integrated with another business? What are the primary concerns of the buyer? 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.
Depending on the situation, it may make more sense to use revenue, while in other situations, an earnout based on EBITDA or a non-financial metric may be more appropriate. There is no one-size-fits-all solution.
Financial Metrics
Earnouts can be based on revenue, gross profit, net profit, or some variation. Sellers usually prefer earnouts based on revenue rather than profits, while buyers usually prefer earnouts based on profits. After all, buyers care most about profits. Therefore, it makes sense to base the earnout on what the buyer values most and what the buyer can actually afford to pay. What if the business produces high revenues but is unprofitable? Where would the money come from to pay the earnout?
An earnout based on revenue may be most sensible for the seller if they will not control the business after closing. If the earnout is based on profits, and the buyer controls the business, the buyer can easily deflate the earnout amount by manipulating the expenses. Earnouts based on profit have a higher likelihood of disputes.
The simpler, the better. Complicating the earnout agreement is a surefire way to lead to disputes. Sellers often prefer simpler performance measurements, such as sales, units sold, or gross profits. These performance measurements are less likely to be manipulated than profits. In transactions that use revenue or some form of earnings as a metric, revenue is used approximately two-thirds of the time, roughly double the frequency of the use of earnings.
Regardless of the financial metric chosen, the parties may continually disagree on how the numbers are measured or how expenses are allocated. The more complicated the agreement and calculation, the more likely there will be disagreements. The higher the metric is on the P&L (e.g., revenue), the less likely there will be disputes.
Non-Financial Metrics
Some transactions use non-financial milestones or targets to measure the earnout. An earnout can be based on achieving virtually any milestone, such as specific events or other results. Any non-financial metric or milestone should be as specific and objective as possible to minimize the potential for disagreement.
Examples include the following:
Some earnouts are structured so that the seller only receives an earnout payment if certain thresholds are met, such as a minimum amount of revenue, or they may be based on the average performance over a specified number of years. The earnout can be all or nothing or proportionate. Other earnouts may involve periodic payments rather than a lump-sum payment at the end of the earnout period. Disputes are common if the target falls short of minimums.
Most earnouts are paid proportionally as a simple percentage of a financial metric instead of being paid on an all-or-nothing basis. But what happens if there are peaks and valleys in revenue or EBITDA? 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? Do the high years offset the low years? What if the revenue is $100 million? Is there an upside limit? Multi-year earnouts are negotiated on a deal-by-deal basis with no standard approach.
Here is a summary of the primary tools for creating thresholds:
Minimums (Cliffs, Floors): With a cliff payment, once a target is met, the earnout is paid. But if that target isn’t met, there’s no payment. In other words, the target is either hit or it isn’t, resulting in a payment or no payment. Earnouts with cliffs are not recommended unless the cliffs are very low.
In other words, if the cliff is $10 million, the seller receives nothing if the revenue is $9.5 million but receives the earnout if the revenue is $11 million. In this instance, an earnout might be worded to pay the seller 5% of revenue only if revenue exceeds $10 million (the ‘cliff’).
Tiers: Tiered payments consist of a series of targets. The earnout can increase or decrease as each target is hit. For example, the earnout might pay the seller 5% of EBITDA up to $3 million, 6% of EBITDA up to $5 million, and 7% of EBITDA if it exceeds $7 million per year.
Maximums (Caps, Ceilings): A cap is an overall limit on the earnout amount and is designed to increase the buyer’s total liability. A cap, ceiling, or limit can be placed in each period (typically a year) or over the lifetime of the earnout. For example, the earnout may pay the seller 5% of EBITDA up to $5 million in EBITDA. If the business generates $10 million in EBITDA, the seller will earn $250,000 ($5 million x 5% = $250k). Or an earnout can pay the seller 5% of EBITDA, but in no event does the seller’s total value of the earnout over the earnout agreement’s lifetime exceed $1 million.
Combinations: Earnouts can also include combinations of cliffs, tiers, and caps. For example, an earnout may pay the seller based on the following schedule:
Sliding Scales: If a cliff is unlikely to meet the minimum for the year, the seller has little incentive to continue exerting effort. A sliding scale is a suitable replacement for a cliff and would pay the seller some bonus, even if the metric fell way short of the target.
Mixed Metrics: Earnouts can also include more than one metric. For example, an earnout can pay the seller 3% of revenue above $10 million, but only if EBITDA exceeds $2 million (the cliff). This example references both revenue and EBITDA. Earnouts that include more than one metric can quickly become complicated.
Cumulative Thresholds: Earnouts can also include cumulative performance thresholds. This is when the seller must make up deficits below the threshold in any period before an earnout is paid. For example, if the earnout pays the seller 1% of revenue above $10 million and the seller only generates $8 million in revenue in the first year, the seller must generate $12 million in revenue in the second year before the earnout begins accruing. If the company exceeds metrics, the threshold may also carry over from year to year. For instance, in the example above, if the seller generates $12 million in the first year, the seller would get paid even if the seller only generated $9 million in the second year since $2 million would carry over from the first period. This is sometimes called a ‘carry forward provision.’ In other words, excesses are carried over to meet minimums in future years. A ‘carry back’ would allow the seller to apply excesses in current years to previous years’ deficiencies. This would allow the seller to make up for missed goals in the past. In essence, the revenue or earnings are being spread throughout the entire period as opposed to constraining the earnout to one time period.
The measurement period is the time period on which the earnout is based. Approximately two-thirds of transactions have time periods from one to three years. There can also be several payment triggers within the time period. For example, the earnout can be based on a three-year time period but have annual payments, which are then based on thresholds such as minimums, maximums, tiers, etc. Most payment triggers are annual and coincide with the financial reporting period (e.g., Jan-Feb).
Shorter terms have fewer variables, while longer terms are more uncertain and more susceptible to external events. Longer earnout periods are theoretically of lower value if measured using a discount cash flow. The further out the payment, the more likely a dispute may be. However, a longer time period may be used if the seller and management team remain to operate the business long-term, but many buyers may grant the team equity instead of an earnout. Some buyers also index long-term earnouts to inflation, so the earnout is based on real growth, excluding inflation.
Although the earnout is based on the business’s performance after the closing period, equity control of the business has shifted to the buyer. To address this conflict, the buyer often gives the seller some degree of control over the business’s day-to-day operations during the earnout period. Without this control, the buyer could manipulate the business to minimize the amount of the earnout payments. The seller can retain rights over key strategic decisions that need to be made, control over accounting practices, or access to financial information. The exact amount of control that is given to the seller is highly deal-specific.
In addition to these provisions, the earnout agreement may contain language that requires the buyer to operate the business in a manner that does not harm the value of the earnout or to operate the business in a manner that maximizes the value of the earnout or to operate the business consistent with past practices. Absent such a contractual requirement for how the buyer is to operate the business, most state laws carry an implied duty of good faith that would indirectly prohibit the buyer from intentionally manipulating the earnout.
It’s critical for sellers to decide in advance what role they prefer to have in the business, if any, after the closing. What is your genius zone? What do you most enjoy doing in the business? Where do you provide the most value? You don’t necessarily need to remain as CEO. Many buyers prefer that you focus on business areas that will grow revenue, such as sales and marketing. This is also where many entrepreneurs excel, but they are often bogged down with management minutiae. If they were relieved of their management duties and could focus 100% of their efforts on sales or marketing, they could have an enormous impact on the growth of the business and, therefore, the earnout. Focus on your core competence, preferably one that makes you happy — whether it be product evangelist, industry events, speaking engagements, content production, integration, sales training, marketing, or some other aspect of the business.
Controls and rights can also be granted in the following specific areas:
The earnout agreement should specify when payments are due, be it quarterly, annually, etc., and in what form the payments will be made (e.g., cash, stock, notes). If payments will be made annually, the agreement should outline exactly when those payments will be made. Will they be paid 60 days after the end of the year? 90 days? What happens if there is a dispute? If the form of payment is shared, a formula must be created to determine the conversion rate. Finally, where does the money come from to pay the earnout? Is this a further expense for calculating the earnout? In other words, is the earnout amount deducted from earnings for purposes of calculating future earnout payments?
The earnout agreement should clearly specify how disputes regarding the earnout are handled. Most earnouts are incorporated into the purchase agreement, and the earnout is subject to the dispute resolutions outlined in the purchase agreement. As an alternative, the parties can draft a separate earnout agreement that contains different dispute resolution options than those outlined in the purchase agreement.
In most cases, an attorney will have strong preferences regarding dispute resolution. Some attorneys strongly prefer mediation, while others prefer arbitration. Attorneys may prefer arbitration over litigation because it’s faster and cheaper, and the parties can choose an arbitrator with relevant knowledge and expertise. The American Arbitration Association exists, but an attorney may consider it expensive. Aside from the standard dispute resolution options, the agreement should include a third-party confirmation option. Under this scenario, a third party, such as a CPA firm, would be retained to make an independent decision. The extent to which this is binding should also be considered. Finally, the impact of a ‘loser pays attorney’s fees’ clause should be carefully considered as the correct answer may be somewhere in the middle in the event of a dispute.
Because an earnout is a deferred component of the purchase price, the seller may retain some protections to ensure the earnout is paid. Most earnouts are an unsecured contractual obligation. While it’s unlikely a buyer will grant the seller the same protective provisions included in a promissory note and security agreement, other provisions can be included to protect the seller. Earnouts have less risk of nonpayment because cash generated from the business can be used to make earnout payments.
Nevertheless, a provision can be included that prohibits shareholder distributions or loans until the earnout payments have been made. This would ensure payments are made first under the earnout before the parent company can extract any money from the business.
It’s also possible that the earnout amount could be held aside or escrowed as it is earned. For example, if an earnout agreement pays the seller 1% of revenue above $5 million, then 1% of revenue could be set aside once revenue exceeds $5 million. This could be immediately ‘expensed’ from the business to ensure these amounts are made available.
If the buyer is an individual, it may be wise to ask that the buyer and their spouse personally guarantee the earnout. The seller could also ask for the earnout obligation to be secured by the business assets; however, few buyers will agree to this provision.
The parties to the earnout must be determined. If there are multiple parties, how are the earnout payments allocated among them? What happens if the seller is unable to continue operating the business due to poor health and the buyer takes over? Would the seller still earn the payments due under the earnout?
What happens if the business is acquired? Would the earnout be assigned to the new buyer? If so, who would be obligated to pay the amounts due? What if any act of God occurs, such as a hurricane or earthquake, or Canada drops a nuclear bomb on us (hey, you never know)? Earnouts are commonly renegotiated when the parties encounter unexpected events, but such renegotiations require a sound working relationship between the buyer and seller.
Earnouts are tricky and difficult to draft. It’s impossible to anticipate every possible event. It’s critical that the buyer and seller maintain goodwill and trust. If so, nearly any potential disagreement can be easily and quickly worked out.
My number one piece of advice in hiring professional advisors is to work with only experienced advisors — specifically advisors who have deep experience buying and selling businesses. An ‘affordable’ advisor lacking real-world experience will prove to be much more costly than the most ‘expensive’ experienced advisors.
For example, it’s common for CPAs to kill deals by offering their unsolicited opinion on a business’s value. They may attempt to use logic that only applies to publicly traded companies or use valuation methods, such as DCF, that don’t apply to small to mid-sized companies. I have heard CPAs claim that an appropriate multiple for a business was seven to nine times EBITDA when, in reality, multiples were in the range of three to four times. Such opinions are common among CPAs. If a CPA or other advisor opines on your company’s value, respond by asking how many transactions they have personally been involved in.
Selling a business involves numerous tradeoffs. Price is always relative to the ratio between risk and reward. 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.
Your advisors should understand the risks inherent in your business, particularly the risks that a buyer will perceive in your business. A buyer’s perception of risks will vary from buyer to buyer. Understanding this will enable your advisor to understand how a buyer’s proposals relate to the overall deal structure and their perception of risk. Your advisor will then be able to propose alternative deal structures that meet both parties’ needs.
The best advisors have deep, relevant experience. They understand their client’s business and industry and are willing to be flexible to meet the needs of both parties. Negotiating the deal involves making numerous tradeoffs. Both you and your advisor must be prepared to be flexible and make concessions if you want to get a deal done. By the same token, your advisor should have the experience necessary to know when a buyer is unreasonable and when it is sensible to advise you to stand your ground.
This understanding is required if they are going to offer their opinion on the transaction structure as opposed to simply accommodating your requests. The most valuable advisors play a technical role and have the requisite experience to add more value than that for which they were retained. This is particularly important when a transaction structure involves an earnout, one of the most complicated deal mechanisms to design. Don’t pay your advisor to learn on the job — ensure you have retained advisors who have significant relevant experience drafting and negotiating earnouts. As a business owner, you likely have no practical experience negotiating an earnout. You must, therefore, solely rely on the advice of professionals. Close collaboration with your deal team will be essential to creating a deal structure that minimizes your risks and maximizes your purchase price.
One of the primary advantages of hiring an M&A advisor lies in their role as an intermediary. Retaining an intermediary to negotiate on your behalf enables you to maintain goodwill and minimize conflicts with the other party. This is valuable when the buyer and seller will maintain an ongoing relationship post-closing. Negotiations regarding price can become contentious. An experienced M&A advisor can keep their cool during these negotiations and insulate you from the stress of negotiating. This can help you focus on your business and minimize interpersonal conflicts with the buyer. This is especially important if your transaction includes an earnout.
An investment banker can also be instrumental in providing a preliminary range of value for your company and preliminary transaction structuring. This could include estimating the possibility and degree of an earnout that may be included in offers from buyers. They can also assess your business and identify risk factors a buyer is likely to perceive, then outline a strategy for mitigating those factors. Ideally, you should build a relationship with your M&A advisor several years in advance so they can strategically advise you on actions you can take to maximize the value of your business.
When working with M&A advisors, it’s also important to understand when your advisors expect to be compensated based on the earnout. Most advisors don’t expect to be paid until you receive the money. 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.
When selling your business, retaining an attorney to represent you is required unless your business is small — less than one million dollars in the purchase price. If your transaction includes an earnout, it’s paramount that your attorney has real-world experience negotiating earnouts relevant to the size of your business.
Your attorney should work closely with your accountant in evaluating and negotiating the earnout. Earnouts have legal and accounting implications, and your attorney and accountant must actively work together as a team to ensure your earnout is properly drafted.
It’s also important to bear in mind that no contract can provide complete protection for both parties. There are too many variables to anticipate and address. As a result, it’s critical that your attorney remain flexible and that you trust the buyer.
Litigation is common in earnouts due to their inherent complexity. Your attorney should be well-versed in common and potential issues in earnouts.
Here is a list of questions and possible concerns for a seller to address:
An accountant will play a key role in drafting an earnout agreement due to the potential tax and accounting implications.
According to generally accepted accounting principles (GAAP), a buyer must estimate an earnout’s fair value and record it as a liability on the opening balance sheet. The liability estimates the amount the buyer will likely owe the seller based on the earnout agreement. The liability remains on the balance sheet until it is paid off and must be re-estimated periodically based on what will likely be paid to the seller.
It’s due to the complicated accounting rules that earnouts are not common with publicly traded firms. An increase in the earnout amount would be recorded as a loss on the buyer’s income statement and would decrease earnings and earnings per share (EPS). In lieu of earnouts, public companies will often pay the seller in stock in the merged entity to motivate the management team post-closing. Accounting for equity is much easier than accounting for an earnout and does not affect the income statement or EPS.
The tax treatment of earnouts is a major consideration for both buyer and seller. The primary question for the seller is whether payments will be treated as capital gains or as ordinary income. For the buyer, the major concern is if the earnout payment is deductible. Unfortunately, the answer is ‘it depends,’ and case law is mixed on the issue of taxation. Regardless, it’s critical that both parties involve their tax advisors as early as possible in the process.
Generally speaking, installment payments are recognized as capital gains income as part of the purchase price. Most forms of individual compensation, such as a consulting agreement, will be taxed at ordinary income tax rates. If the payment is deductible by the buyer, it will almost always be treated as ordinary income by the seller. Therefore, the parties are at odds with one another- the buyer prefers that the payments be deductible, while the seller prefers that earnouts be treated at ordinary income tax rates. The potential tax situation of both parties can be taken into account. For example, the seller’s marginal tax bracket should be compared with the buyer’s likely taxation to minimize the total amount of taxes paid — regardless of who pays them. In other words, with proper tax planning, the pie can be made bigger by allocating the earnout payments to the party with the most favorable tax position and then splitting the tax advantage between the parties.
It’s also possible that the tax implications will change over time, especially with a change in the presidential administration. An accountant or CPA should examine whether the tax rates are based on current rates or the tax rates when the business was sold.
