Earnouts in Mergers & Acquisitions: Pitfalls & Difficulties to Avoid
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.
Earnout defined
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.
Earnout 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.
The Art of Drafting Milestones for Earnouts
It is always sad to see former stockholders denied claims they are entitled to be paid in milestone payments under a merger agreement. In my opinion, I believe most buyers prefer to pay earned milestone payments, in particular, if the former stockholders are now employees. Hiring an expert can help facilitate fair terms and can save time and money. Remember, value is always in the eyes of the beholder.
The valuation gap debate
Earn-outs are generally used as a tool to bridge a valuation gap. A valuation gap is a difference between the actual market value of a company and the value the owner expects to sell it for. For this reason, there are often dozens of negotiations required to make this gap as small as possible. Forecasts are often slightly inflated and an earn-out is therefore generally a fair compromise. With that said, valuation gaps remain one of the most common reasons that many mid-market transactions fail to close.
Milestone cat and mouse
In order for the deal to succeed, buyers will often propose future payments based on successfully achieving milestones built into forecasts. The seller will then generally seek clarity on the definition of success to ensure that the milestones are reasonable and achievable. This back and forth can go on for months. Occasionally buyers will need to deploy additional capital for investments to achieve the projected numbers. The necessity to make further investments can expose the buyer to additional risk. The milestone payments can be a strategy to recoup some of the investment capital if the seller was overly bullish when presenting projections to the buyer.
The drafting process
Once general terms are negotiated, the actual drafting takes place and this is where lawyers and M&A experts will get involved. Milestones are generally highly specific and based on multiple factors. Below we provide some general rules you should follow when drafting milestones.
1) Make your expectations realistic
This ultimately comes down to the valuation gap. As the business owner, you should step back and ask if your expectations are reasonable or too aggressive. If you set aggressive milestones, you are opening yourself up to increased risk and setting yourself up for the potential of failure. Both parties will need to negotiate, and often met in the middle.
The majority of M&A deals fall short of the set expectations. This doesn’t necessarily mean the deals are failures. Projecting future earnings and business metrics is not an easy task. Solid and realistic expectations for the earn-out will prepare you well for the negotiations.
2) Keep it Simple
The simplest earn-out is none at all. Additional cash is great, but this could come in the way of a salary for 3-5 years vs. setting earn-out goals. Like any deal, there is a substantial risk of failure and these risks may involve factors outside of your control. I have seen earn-out deals with an extremely complicated matrix of variables and goals. Fair to say, I normally see the founder’s equity/cash pulled back by the buyer. A buyer who has set out a complicated set of goals that span earnings, customer retention and sales should be challenged.
3) Avoid Common Pitfalls
Although the goal is to keep the earn-out structure as simple as possible (or avoid one altogether) you might still be interested in having something in place. If you believe wholeheartedly in your company’s potential, and want to continue to guide its success, an earn-out can give you the opportunity to do so. However, we suggest thinking about the following things before you accept this new challenge.
- Keep your key players. You know the key people in your company. Be careful if you don’t have these players behind you post-acquisition. You do not want to start building a team from scratch during your earn-out period.
- Keep the length of your contract as short as possible. An earn-out might sound like a good idea but avoid long contract terms. This will minimize “burn-out” risk.
- Make sure you have control. Make sure you are only accountable for what you can control. If the buyer shuts down a division you need to operate, this could eliminate your pay-out or force a clawback.
- Ensure that incentives are in place. If you’ve made a lot of cash in the initial sale, it’s natural to lose enthusiasm for the future goals of the company. Structure the earn-out in a way that you know will keep you motivated. As mentioned above, a short contract term helps with this.
4) Aid Wins, Avoid Losses
Talking and discussing the multiple outcomes with the buyer in advance helps. But remember, they will never make it easy. You will need to have a simple, clear-cut plan and procedure for earn-out to pay-out. Here are some questions you should ask.
- Will you have autonomy? The best earn-out outcomes are generally when the seller is allowed to continue running the company as they did prior to the acquisition. If this is not possible then consider including some clawback terms in the agreement to protect yourself.
- What is the purpose of the earn-out…financial or strategic? It is hard to get a clear answer here. In fact, this can be where the trust breaks down between the buyer and seller. An earn-out made for financial reasons is generally when the buyer has faith that the owner can expand the business and achieve the projected results. Rule of thumb: if the acquirer keeps a respectful distance and seems to be giving you autonomy, this is a good sign. A strategic earn-out is where the buyer wants you to fail. Of course, they will not tell you this, but warning signs here are micro-management and a confusing matrix of metrics you need to hit.
- How will the earn-outs goals be evaluated, and by who? It sounds simple, but murky terms can lead to debate down the line. Ask up front who will be evaluating the earn-out metrics under new ownership, and when these evaluations will take place. Although there’s no right answer, these questions should be addressed early on in your negotiations.
- How will outside events impact success? There are dozens of factors in business that neither party can control. This can, however, impact the ability for you to maximize the rewards pledged in the earn-out. These can be anything from an economic downturn to a natural disaster. Make sure to create contingency plans to address the most unlikely of scenarios – especially if you’re entering into a long-term earn-out deal.
Earnout Details Are Critical
When drafting the language for an earnout it is not possible to pay too much attention to detail. As they say, the devil is in the details. The language used can benefit either the buyer or seller. For example, if future payments are tied to EBITDA this benefits the buyer. Once the company is sold, corporate expenses could be pushed down to a divisional level that ultimately hurts EBITDA. Alternatively, payments tied to future revenue typically favor sellers as revenue tends to be a rather clean figure.
However, sellers should still be wary of earnouts tied to revenue figures. It isn’t uncommon for revenues to dip following a transaction. This is due to the fact that the new owners are trying to learn about the business while keeping it running. If the learning curve is particularly steep, revenues could suffer for an extended period of time. This will hurt a seller’s chance of maximizing their earnout.
Revenue can also be curtailed if the new owner doesn’t commit capital to marketing and business development. If the seller expects the buyer to start, or continue, an aggressive marketing campaign they may be in for a rude awakening. A buyer may be more than happy to reduce the marketing budget for a year if that means the seller will not hit the targets to trigger an earnout. If the buyer is able to pay $10M for a business, as opposed to $20M that includes earnout payments, don’t expect them to engage in a strong promotional campaign to help you.
Protect Yourself
Sellers need to consider a variety of factors prior to agreeing to an earnout. Various events can occur during the earnout period that reduce, or eliminate, the payments a seller expected to receive.
One such scenario is when a company is sold to an even larger company. After the sale you cannot expect decisions to be made in the same manner as when you were running the show. Larger corporations are notorious for slower decision making and “red tape”. The slower decision making and new procedures to implement a decision may greatly increase the time it takes to effect a change. This slowdown could jeopardize your ability to maximize your earnout.
Another scenario to consider is the buyer taking on additional expenses during the earnout period. Expenses that hurt EBITDA today, but are expected to produce value in the future, may benefit the buyer. The seller may not be as fortunate. If expenses are incurred today to generate revenues in the future, the buyer will benefit. The seller will not.
Finally, it is important to consider the various unexpected events that may take place during your earnout. A hit to the economy, a natural disaster, fraud within the company, and a variety of other possibilities should be taking into consideration. It is impossible to plan for every adverse scenario, but a diligent seller will spend some time thinking about what could happen to the company, how it will impact their earnout, and how they can work with the buyer to mitigate the risk.
Considerations When Structuring an Earnout
Earnouts can be a double-edged sword. They are common in many deals and can be structured to benefit the buyer or seller. If you plan to use an earnout when selling your business, consider the following:
- What will the business look like post-sale if growth slows? Will you still consider the deal to be worthwhile?
- If your earnout is tied to revenue, ask the buyer to commit to full sales & marketing support on day 1. Be sure this doesn’t impact your earnout calculation.
- Ensure the earnout and payment calculations are crystal clear. Any ambiguity could be used against you.
Sellers should also understand that their willingness, or lake thereof, to consider an earnout can be a signal to a potential buyer. Sellers that adamantly refuse to consider an earnout are signaling that they do not have faith in the future prospects of the business. Certain buyers may view this as a red flag and proceed with caution or abandon discussions entirely.
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.
Conclusion
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.
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