Effective Use of Earnouts in M&A Transactions         

By Kelly Reiman

Earnouts have been used over the years to bridge the gap between the seller's perceived value of its business and the buyer's willingness to pay for anticipated future results. Counsel to the parties and their business brokers can be instrumental in setting realistic expectations for them and crafting the provisions to ensure success. 

The Business; The Parties  

While an earnout can conceivably be drafted for every business, certain businesses lend themselves better to the achievement of the objective. Those businesses with a recurring stream of revenue are better suited than businesses that have a singular milestone that serves as the marker for payment. Some of the reasons for structuring an earnout are if the seller has just introduced a new product and wants the purchase price to capture some of the upside, or if there are strategic reasons for the transaction, such as the seller wanting a particular purchase price and the buyer wanting to complete the transaction as a part of a larger corporate strategy or if the seller is part way through a large contract and a substantial portion of the profit is back end loaded.

You should also consider whether the key personnel of the seller are intended to be long term employees of the buyer. If these personnel, be they employee-owners or key management personnel, will only be with the buyer for the earnout period, the odds of success diminish. A review of the buyer's management style, the role of the key personnel of the seller with the buyer post-closing and the buyer's corporate structure are important components to analyze. The more that all of these components are inherently present within themselves post-closing, the greater the chance for success. In other words, if the seller's key personnel will remain in basically their same positions with the buyer and the more the buyer's management style and structure will seamlessly accommodate the necessary management support and corresponding reporting inherent in the concept, the greater the likelihood of success. In fact, without them, you should consider alternatives, and the parties should closely analyze them before proceeding. 

Tension Between Seller and Buyer

The negotiations surrounding the provisions of the purchase and sale agreement related to the representations and warranties, which largely center around risk sharing between the parties, pale when you consider the tension between the seller and the buyer regarding the earnout. While seller and buyer generally believe an earnout aligns the interest of the parties, closer analysis is necessary. It's true that the earnout is generally designed to produce increased revenues, which benefits both parties. But the structure of the earnout is critical as the seller is more interested in the short term, and generally desires to continue running the business as the seller ran it without interruption, whereas the buyer wants to incorporate the business immediately into its governing structure, which inevitably leads to changes. The advisers can, and should play a vital role in harmonizing these conflicting goals. 

Designing the Earnout 

Aside from the obvious design features of a short earnout period, realistic benchmarks, and the establishment of the applicable accounting and reporting principles, sellers need to understand they will be operating within an entirely new construct. Perhaps the most important documents related to the earnout are the buyer's employment (or comparable) agreements with the seller's key personnel. These agreements need to be coordinated and should include termination only for cause provisions, even if that is only for the earnout period. The employees' scope of authority needs to be consistent with their ability to achieve the earnout and the buyer cannot change it without the seller's approval. Consider whether their physical presence is important at a particular location. And encourage the seller to share a portion of the earnout with key personnel. Include proper incentives and since their employment with the buyer needs to be assured, consider a non-compete and/or confidentiality provisions for the earnout period (even if not otherwise present). If the buyer terminates the personnel during the earnout period, the benchmark should be lowered. And consider whether there should be a mandatory buyout if the buyer sells the business during the earnout period. 

Conclusion          

Earnouts can be tremendously useful to bridge the value gap between the seller and buyer. Careful analysis of the personality traits of the buyer and seller organizations is an often overlooked, and critical first step. Assuming an earnout is the proper tool, designing the provisions to produce symmetry between buyer and seller should lead to a successful outcome for both parties. 

(originally published in June 2012 eNewsletter)

Kelly Reiman is a principal in the firm of Engel & Reiman pc and chairs its Tax and Business Planning Department.  He has been licensed in Colorado since 1983 and holds an LL.M. in taxation.  His areas of practice include mergers and acquisitions, private equity, real estate and general business planning.  You may contact Kelly at info@engelreiman.com.