Key Considerations When Negotiating Earnouts

Earnout provisions are increasingly common features in mergers and acquisitions, particularly where there is a gap between buyers’ and sellers’ valuation expectations. Earnouts bridge the gap by providing the seller with an opportunity to earn additional purchase price that is contingent on the post-Closing performance of the business. If the business performs to the degree the seller expects, the seller is rewarded with additional purchase price; if it does not, the buyer has no obligation to pay anything extra. The earnout concept can allow both parties to prosper, but demands provisions that are properly thought-through, negotiated, and documented. Earnouts are often one of the most heavily negotiated aspects of an M&A transaction—both sides must be cautious and precise when thinking through how an earnout could suit their deal.

• Performance Metrics: Earnouts are generally based on the financial performance of the target business post-Closing. The amount of additional purchase price usually depends on revenue or EBITDA goals set for the target business, often styled as a band between a performance floor and a performance ceiling. If the target business meets or exceeds the ceiling, the seller is entitled to the full earnout amount. Likewise, if the target business fails to reach the floor, the seller is not entitled to any earnout proceeds. Should performance fall within the band, a formula will generally govern the final amount of earnout earned. The governing financial goals, band range, and resulting earnout amounts due and owing are each carefully negotiated on a deal-by-deal basis.

• Duration: Earnouts are most commonly measured over a 1–3 year duration. In some cases, the business is allowed to “make up” for a down year (in which no earnout was earned) in subsequent years (in which financial performance exceeds the ceiling). The parties need to account for the target’s business cycles, industry-specific considerations, and post-Closing macroeconomic environment in order to set an appropriate duration.

• Payment Structure: In addition to determining if the seller will get paid (performance metrics) and when (duration), the parties must negotiate how an earnout will be paid. Will the seller receive cash, equity securities, or a mix of both? Will payment be due in one lump-sum at the end of the duration, or in periodic payments throughout? Even when an earnout payment becomes due and owing, will the buyer be afforded a right of set off against that earnout payment as an additional manner of recourse against the seller? Control and Operations: A noteworthy (and very deal-specific) consideration is the amount of control both sides should have when running the business post-Closing. Generally speaking, a buyer taking a controlling stake in the target will demand autonomy to run the target business as it sees fit, even if the business decisions made are not the most advantageous path toward the seller receiving earnout payments. A common protective device for sellers, however, is a covenant that the buyer not taken actions specifically calculated to avoid earnout achievement. The seller is also generally provided with access to the business’s books and records to monitor earnout progress.

Earnout mechanics can be an extremely valuable tool for both buyers and sellers to get a deal done while incentivizing both sides to boost financial performance post-Closing. Nixon Peabody can help you assess the optimal earnout structure for your deal, regardless of whether you fall on the buy or sell side.