An earnout is a mechanism in M&A transactions that allows the seller to receive additional compensation if the business achieves certain financial or operating targets after closing. Earnouts can bridge a valuation gap between a seller and skeptical buyer and are often used for startups that don’t have much operating history but have growth potential.
There aren’t any hard and fast rules when it comes to structuring an earnout, meaning there are a number of structural considerations that are open to negotiation. This article examines some of those key considerations.
Performance Metric: There are various options when considering what metric will be used for performance targets. Some common financial metrics include revenues, net income and operating cash flow (EBITDA). Sellers often prefer revenue because it is the easier to measure and is not reduced by things like discretionary expenses or overhead allocations. Buyers favor net income because it can provide a more complete picture of the business’s value to them. There are other, non-financial metrics that can be used. These can include things like product development milestones or number of customers/users.
Earnout Period and Payout Structure: The typical earnout period is between three and five years, but there are some circumstances in which parties might require a longer period to adequately assess the performance of the acquired business. The length of the period can vary depending on the business plan and nature of the products involved. Earnout payments are often made on an annual or semi-annual basis. If the aggregate earnout payment will be capped, the parties will also need to decide whether each installment payment will be capped and how to handle installment payment shortfalls.
Accounting Guidelines: Buyer payments should be accompanied by financial information supporting the calculation of the payment. It is recommended that parties establish specific accounting guidelines as a supplement to generally accepted accounting principles (GAAP), which permits a range of accounting practices. This can help avoid future disputes. It is also a good idea to include a mechanism using someone versed in accounting, such as an independent auditor, to resolve disputes in the event an accounting dispute does arise.
Level of Support/Control: It is important to determine what level of support a buyer will be required to provide the acquired business and the degree of control that the seller will have over the business during the earnout period. Buyers will often resist sellers being overly involved in the business after closing, while sellers typically insist on the buyer agreeing to use best practices to utilize the business. It can be difficult to find the right balance between the buyer’s desire to run the business as it deems appropriate and the seller wanting to protect its ability to achieve the earnout.
Other Events: Sellers will also want to make sure the earnout specifies what happens if the acquired business is sold or there is a change in control of the buyer (i.e., the acquirer and/or the buyer will be responsible for the earnout). They might also want the right to reacquire the business if it appears the buyer is headed for bankruptcy.