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Understanding Earnouts in M&A Deals

In today’s merger and acquisition environment, buyers and sellers often have very different views of the value of the company to be acquired. Sellers believe their business is worth more than the diminished profitability of the past few years indicates, and they attempt to increase the purchase price by emphasizing the business’ overall historical success. Sellers usually assume profitability will be resurrected and that they should not be penalized due to what they view as a severe, but temporary recession. Buyers, on the other hand, do not want to pay a price which substantially ignores the company’s relatively reduced recent performance. Unless some method to bridge this gap between a seller’s optimism and a buyer’s less rosy view of the company’s prospects is found, it is nearly impossible to agree on a price and to cut a deal.

An earnout is one method M&A lawyers use to bridge this value perception gap. In its most basic form, when a purchase and sale contract contains an earnout, the buyer agrees to pay additional purchase price if the acquired company achieves certain defined goals. In effect, it provides a method where the seller is rewarded if increased profitability or other indicia of improved performance occur, and the buyer avoids being penalized by paying more if the company underperforms.

The earnout goals are usually one or more of the following:

  • A specific increase in revenues
  • A specific increase in earnings
  • A specific increase in gross profit
  • Attainment of one or more specific goals, such as retention of a key customer or renewal of a significant contract.

Earnouts can be based on the results of one or multiple years and can be paid at one time or over a period of years. Everything is negotiable, including the additional amount to be paid if the goal(s) is achieved.

While the use of an earnout can seem to be an eminently reasonable way to bridge the buyer’s and seller’s differing perceptions of value, in fact, it can be difficult to craft one that is not subject to manipulation.

Here are two simple examples: A buyer agrees to pay a designated earnout if an increase in EBITDA (earnings before interest, taxes, depreciation and amortization) is achieved. In order to avoid this result, the buyer increases inventory and accelerates purchases, capital expenditures and other expenses to reduce earnings. Or, consider the inverse, a seller continuing to manage the business defers all maintenance and repairs in order to increase profitability. In either case, the underlying rationale for using the earnout is defeated.

Given the current economic climate, earnouts are a frequently used and important tool in the M&A world. In order to achieve each party’s objectives, however, its use in each unique deal must be thoughtfully analyzed and its description in the deal documents must be carefully drafted.

If you have any questions or would like more information, please contact your Davis & Kuelthau attorney.