When the purchaser and the seller of a business are not able to negotiate an agreed-upon price to be paid at closing, one option is to incorporate an earnout provision into the transaction document. In layman’s terms, the seller agrees to a lower upfront sales price in exchange for the purchaser’s promise to make additional future payments based on a period of profitability or other predetermined benchmarks after the closing of sale – an earnout mechanism.
A “simplified example” would be an agreement to purchase a business – usually privately held – at the price of $50 million with an earnout of 5% of gross sales in each of the first three years of the buyer’s operation of the business, explains Investopedia.
Earnouts must be carefully, thoroughly negotiated and drafted
Many negotiated earnouts are compromises with detailed, complex terms. Earnouts exemplify the tension of the buyer wanting to operate the purchased business however it deems appropriate with the seller wanting the buyer to maximize payment under the earnout. Examples of typically negotiated provisions may include:
- Buyer agreeing to use reasonable business practices and not taking any intentional actions that would negatively impact the earnout.
- Both parties, but most particularly the buyer, agreeing to proceed in good faith and with fair dealing.
- Buyer agreeing to keep a level of consistency between pre-closing and post-closing operations, including the retention of key employees, executives and managers.
- Designating and defining metrics to measure the financial goals that will trigger the earnout, e.g., gross revenues, EBITDA, net income or gross profits.
- Designating other events (i.e., signing new clients, receiving government approval of a license or a product safety designation, receiving a patent or trademark, or completing an invention) that will trigger all or part of the earnout payment.
- Defining an applicable accounting standard and definitions.
- Establishing minimum thresholds and caps on earnout payments.
- Determining the time period (likely one to five years) of earnout eligibility and fiscal periods (e.g., calendar years) during which goals will be measured.
- Transparency of the buyer’s financials relating to earnout metrics as well as the seller’s right to audit and inspect applicable books and records.
- Determining triggers, if any, that would accelerate earnout payments.
- Establishing a dispute-resolution methodology, such as binding arbitration, and naming an independent auditor to assist with disagreements related to the earnout metrics.
- Establishing incentives for the seller or its founders to remain active in the business post-sale.
- Defining tax and accounting treatment of the earnout payments.
Compromise of tension between buyers and sellers
Earnout payments can be an effective tool to allocate valuation risk between the seller and the buyer of a private company. Careful drafting and negotiation of earnout provisions by the parties and their legal counsel are crucial to minimizing areas open to interpretation and potential post-closing disputes. If the parties are aligned with the terms and metrics of an earnout, those provisions are often the deal terms that get a transaction over the finish line.
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