18 Jun Earnouts: Difficult to Craft, Harder to Implement
We have spoken previously of the double-edged nature of most earnout agreements in M&A. While earnouts have some benefits, there remains difficulty in negotiating, crafting and implementing them successfully. Here we discuss some of these varied nuances.
When buyer and seller come together, a buyer is often concerned with the sustainability of historical earnings into the future. Consequently, buyers use earnouts as a method to both compensate and motivate sellers based on future earnings potential of the business. In most cases, additional payments are made to the seller if the earnings meet or exceed a defined threshold. In some cases, an earnout may pay out debt or note given to the seller is paid early given certain earnings numbers are met.
Earnouts require the following:
1. Consideration for the earnout: stock vs. cash.
2. Measurement of performance: income, cash flow, EBITDA, net income, etc.
3. The measurement period: how long will the earnout last?
4. The timing of payments over the period.
5. Defined maximum limits of the earnout payment
Why use an earnout?
Without stating the obvious, buyers are sellers often have a difficult time coming together when determining value. This is a real threat to killing a deal. It usually stems from the expectation of future cash flows. Buyers typically rely on the seller’s projections for future earnings. Buyers and sellers will often disagree relative to the company’s ability to recognize the projected results of future earnings. When these assumptions are used to set the price of the business a buyer may be willing to ride with the higher assumed valuation the seller desires with the caveat that some portion of the premium is paid if the cash flow projections are realized. With an earnout the buyer only pays the premium above fair market value when the earnings are actually realized. The buyer will also fully realize the value of the business only if the assumptions on future performance are actually realized.
Difficulty with earnouts
An earnout may include something like the following:
Additional payments from the buyer to the seller once a year for three years, given specific earnings numbers are either met or exceeded.
Simple in concept. Difficult in implementing. Earnouts naturally have several difficulties in their implementation. First, the buyer will want to make sure any future earnings included in the earnout payments come from normal business operations and not necessarily from significant, extraordinary or one-time events. Second, an earnout is likely to assume the exclusion of synergies. That is earnouts may not include the hybridization of the businesses and additional realized value from the combination. Said differently, if after the acquisition, the buyer combines his/her business with the target and realizes a large boost in sales, it may not be easy to quantify or separate how the synergies impacted the bottom-line. Defining all the nuances as part of the earnout can be costly, difficult and time-consuming.
Seller concerns with earnouts
The concerns and desires of the buyer are juxtaposed with the seller who often desires that immediate changes to operations do not negatively impact the company’s ability to perform during the time the earnout is in place. In this case, the seller will often request provisions that exclude goodwill from being used in making calculations of future value as operational changes could significantly impact goodwill. In addition, the seller is also likely to request that the operations be run consistent with historical performance to ensure earnings remain at least consistent with the past.
Because of the ability of the buyer to manipulate the businesses operating expenses post-close, many an earnout may be pegged against gross profit and not net income, EBITDA or cash flow. If the earnout is based on some percentage of gross profit of the historical business, it makes it less difficult for the buyer to monkey with how much earnout is to be eventually paid. The seller will want to ensure goodwill is ignored in making calculations and that the company will be consistently operated on par with historical performance. The seller may also want to look directly at interest charges, intercompany transactions and depreciation with the buyer’s company. Ignoring expenses “below the line” can help bridge the gap here.
Sellers may often be concerned with the requisite thresholds. What if the buyer requires a minimum gross profit of $10,000,000, but the seller hits a gross profit of only $8,000,000 for the earnout period in question? To avoid such binary outcomes, the seller may wish to require a sliding-scale earnout to ensure at least some premiums are paid based on the continued operations.
Seller’s may also be concerned with the potentiality of earnout provisions that require the return of previous earnout payments if future performance that still occurs during the earnout period is substandard. For example, if the company performs well in year 1, but does poorly in years 2 and 3 of the earnout, the buyer is likely to require remuneration or refund for the first earnout payment.
Accounting & tax issues
One of the positives of earnouts from the seller’s perspective is the ability of the seller to spread tax obligations for consideration of the sale over several years. If the buyer is looking for a tax-free reorganization, contingent shares must be issued within five years of deal close. In this case, the buyer must obtain a tax deduction where the earnout is paid as compensation under an employment agreement to the seller. This is difficult for the buyer to negotiate as the seller will obviously want to be charged capital gains on the earnout proceeds and not have it considered as “real income” for tax purposes. We have had direct experience with this issue in the software & information technology sector. If this is too hotly-debated, it is often worth it for the buyer to pay the true-up on the tax for the seller to make-up the difference in tax as s/he receives a greater benefit in the tax-free reorg.
*When it comes to tax-free reorgs, difficulties arise in cash vs. stock vs. membership interests. Keep in mind, this is for example purposes only. In crafting the right structure for both buyers and sellers, competent tax and legal assistance is advised.
Alternatives to earnouts
While alternatives to earnouts exist, they are mostly buyer-controlled. A few alternatives for consideration include stock, warrants, preferred stock or other contingent instruments. Buyers need to beware of setting a guarantee on the price of the stock if stock is used as an alternative. If the buyer’s stock value goes in the toilet, the buyer may find herself in a situation where the seller now owns a large portion, or even a majority, of her company. This is not a good position.
Creating a legal agreement that fully covers all the potential issues inherent in an earnout is nigh to impossible. There are simply too many variables in how the earnout could proceed. Buyers and sellers must rely on the explicit terms, the good faith of the parties and/or the business judgement one another—all of which can be difficult. Acquisition negotiations are difficult enough when buyers and sellers quibble over various nuances. Bringing in something as hairy as an earnout can significantly increase the difficulty in completing the M&A negotiations. Often earnout provision negotiations are left to the 11th hour of a deal and can create unwanted conflict in getting a deal over the finish line. Earnouts do help to bridge the gap, but they represent a less-than-ideal solution in many cases for many of the reasons we have discussed here.