Eye on Earnouts
M&A activity has grown during the COVID-19 pandemic. That trend is expected to continue in anticipation of higher capital gains tax rates under the Biden administration. Earnouts — which may spread the potential tax liability over a number of years — have become particularly common for deals that happen during these uncertain times. Before negotiating a transaction, it’s important to understand how earnouts work and how they can help facilitate deals.
Put Earnouts in Your M&A Toolkit
In a business acquisition, the buyer and seller may have difficulty agreeing on the business’s value. With an earnout, the seller enjoys the fruits of its labor if the company performs as expected. At the same time, the buyer is protected from overpaying in the event the acquisition target’s performance falls short of projections.
Earnouts can be incorporated into seller-financed deals. Here, a seller might agree to accept a lower payment at closing along with held interests and the promise of receiving additional remuneration if the business meets certain financial milestones. As the buyer pays these remunerations, the seller releases the held interests. The seller may maintain rights to assets of the company should the buyer fail to meet a specified schedule.
Spell Out the Terms
Earnout provisions have several components. A financial professional can help the parties establish a quantitative formula to determine how much is to be paid if the business reaches a certain financial target.
For instance, a buyer might be willing to pay the seller 10% of annual earnings that exceed the previous year’s earnings by a certain amount. The target also might be based on annual cash flow, sales, or other metrics. The payout provision specifies when and how many payments are to be made.
In most situations, the earnout term runs three years or less. A longer period can subject the seller to additional risk because it increases the possibility of adverse business events that are beyond the seller’s control. If a longer period will be used, the seller might consider financing in the form of a loan or preferred stock in the company — both of which offer remedies in the event the business is mismanaged and the buyer can’t meet its financial obligations.
Anticipate Potential Contingencies
Earnout provisions also address certain contingencies that could affect the business’s ability to reach the agreed-upon milestones. Say, for example, an acquired company is required to achieve a specific level of earnings. After the sale, the new owner decides to write down the value of a large asset or invest in expensive new equipment that boosts depreciation expenses. Or the company may be required to adopt accounting rule changes. These types of developments could significantly lower earnings, causing a seller to lose out on one or more earnout payments.
The seller may require regular open-book access to accounting reports and other proof of financial operability to ensure accurate earnout payments. The parties will also need to address “Acts of God,” receiving insurance proceeds, selling the business early, and arbitration procedures (in case of disputes). Finally, to avoid disagreements in the future, both parties should specify how they expect each contingency to affect earnout payments.
An earnout can help bridge a valuation gap and ensure that a deal will be beneficial for both parties. Contact an outside financial professional during deal negotiations to develop an earnout provision that covers all the bases.