One of the biggest challenges in pursuing acquisitions in the current economic situation is grappling with the parties’ expectations regarding the value of the acquisition. Fortunately, there is a solution, known as an earnout, which can help close the valuation gap during any transaction that involves the purchase or sale of a product or service.
What are Earnouts?
Earnouts are a type of mechanism that allows sellers who are engaged in a transaction to collect value over and above the closing date if the acquired business in question performs up to a specific predetermined standard. Earnouts come in a variety of forms, but always have the following two features:
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- One or more contingent payments of the purchase price after closing; and
- Contingent payments becoming payable upon achievement of certain predetermined financial targets (during the earnout measurement period).
Earnouts have a number of advantages for both buyers and sellers. For example, buyers who use the earnout method have a lower chance of overpaying for a product or service. For sellers, on the other hand, the earnout provides an opportunity to finalize sales in an uncertain economy, while also potentially achieving a higher overall purchase price.
What to Address in Your Contract
Parties who decide to use an earnout clause during a purchase and sale transaction will need to address a number of related issues, including:
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- Post-closing operating covenants that will act as limitations on a buyer’s ability to make changes to the acquired product during the earnout measurement period, such as a restriction on the sale of company assets or a prohibition against terminating key members of management;
- The length of the earnout measurement period, which typically ranges from one to three years;
- Whether the parties agree to a buyout option, which allows buyers to terminate the earnout obligation before the end of the measurement period;
- Whether the contract will contain a provision regarding a forced buyout, which would result in an acceleration of earnout payments if certain specified material events occur after closing;
- Which financial metric the parties will use, which could include the EBITDA financial metric, a standard that accounts for some costs, but excludes others;
- The payment structure of the earnout, which includes an assessment of whether the parties will use a fixed amount or a percentage of the specific target and whether the payment will be based on a sliding scale or consist of an all-or-none payment; and
- The tax repercussions of using an earnout.
Ultimately, how these factors affect a person’s contract will depend on his or her specific circumstances, including the type of sale or purchase in question, the agreed-upon price, and the state of the economy at the time of the transaction.
Is an Earnout Right for You?
The use of earnouts is not limited to mergers and acquisitions. In fact, earnouts can be stipulated in any purchase and sale transaction, so if you have questions about how to use an earnout in your own negotiation, please reach out to an experienced business law attorney for help.