Understanding Earnouts In Mergers And Acquisitions

Keep these important issues in mind when drafting earnout provisions in M&A agreements.

An “earnout” is a contractual mechanism in a merger or acquisition agreement, which provides for contingent additional payments from a buyer of a company to the seller’s shareholders. Earnouts are typically “earned” if the business acquired meets certain financial or other milestones after the acquisition is closed.

An earnout can be useful if the parties are having difficulty reaching agreement on an upfront cash price, with the earnout as a way of bridging the different views on valuation of the buyer and seller.

Earnouts are primarily used in connection with acquisitions of privately held companies, although in some rare instances earnouts are incorporated in acquisitions of publicly held companies.

Earnouts often lead to disputes between the seller and buyer as to whether the earnout was in fact earned or whether the buyer improperly prevented the earnout from being maximized.

In this article, I discuss the important business, legal, and drafting considerations for earnouts to minimize the likelihood of disputes.

The Buyer’s Perspective on Earnouts

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Buyers view earnouts as providing several benefits. First, the total price to be paid for the acquisition can be based on the seller’s future performance rather than solely on the seller’s projected performance. This can minimize a buyer’s risk of overpaying for a company.

Second, an earnout can work as a motivational and retention mechanism for the seller’s key management team to continue operating the business successfully after the acquisition has closed.

The buyer will often want maximum flexibility with respect to how it can operate the acquired business post-closing, especially as circumstances and the business environment changes. The buyer does not want to be hampered by unduly harsh restrictions, covenants, or seller protective provisions. There is direct tension on this issue between seller and buyer.

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The Seller’s Perspective on Earnouts

Typically, the seller wants to receive as much of the purchase price in cash up front upon the closing of the acquisition.

But if a seller is willing to agree to an earnout, it will have the following key concerns:

Are the earnout milestone targets reasonably achievable in a reasonable time period?
How can the seller make sure the buyer doesn’t operate the business in a way that minimizes or eliminates the earnout payments?
What commitments will the buyer give to support the business and optimize the likelihood that the maximum earnout will be earned?
Is the amount of the potential earnout payments significant enough to delay the seller getting all cash up front?
How can the seller protect itself from the buyer manipulating the financial metrics of the business in a way that adversely affects the earnout payments?

Key Initial Considerations in Structuring Earnouts

When structuring an earnout, there are a number of key issues to consider, including:

Financial metrics to be used. Earnouts are typically structured so that EBITDA, gross revenues, or gross profits milestones need to be met. Buyers will often prefer an EBITDA milestone, arguing that it will be the most reliable indicator of the value and profitability of the business. Sellers resist EBITDA-based milestones due to concern that the buyer can manipulate EBITDA by incurring additional costs during the earnout period that will benefit the buyer after the earnout period is ended. Sellers prefer a milestone based on gross revenues of the business, as it is less subject to manipulation by the buyer. Gross profit (net sales minus the cost of goods sold) is sometimes used as a compromise milestone, although sellers are still wary of this metric.
Earnouts involving non-financial metrics. Milestone earnout payments can also be structured upon the attainment of non-financial goals. For example, earnouts are often included in bio-pharma acquisitions, with milestones pegged to the success of clinical trials or FDA approval.
Time period. Over what period must the financial milestones be met before the earnout is earned? Is it gross revenues for the current year? Is it EBITDA for the next three years with some amount of the earnout earned each year? Is it all dependent on cumulative EBITDA after three years or the EBITDA in the third year? Or some other formulation? Earnouts are typically over one to three years.
All or nothing or graduated payments? Is there an absolute milestone that must be met before any payment is earned (e.g., $100 million in gross revenues in 2022) or graduated (e.g., $80 million to $120 million in gross revenues in 2022, with graduated earnout payments based on actual gross revenues met between $80 million and $120 million)?
Minimum and maximum payments. Some earnouts require a minimum payment in the future, and many earnouts establish a maximum payment. If a minimum payment is required in the future, the seller will want the buyer to put that minimum amount into an escrow to ensure it is paid.
Accounting standard to be applied. What accounting standard is to be applied to determine if the financial metrics have been met? The seller’s accounting standards prior to the closing of the acquisition? GAAP consistently applied? The buyer’s accounting standards? How will synergies and intercompany charges and allocations be dealt with?

Covenants/Protective Provisions in Earnouts

The parties will negotiate for various obligations and covenants of the buyer to protect the possibility that the earnout will be paid and maximized. Here are some of the types of provisions negotiated:

Good faith and fair dealing. At a minimum, the seller will ask for an obligation of the buyer to operate the acquired business in good faith and to deal with it fairly.
Actions or omissions. The seller will often ask for an obligation from the buyer that it not take affirmative actions (or omit to take action) for the purpose of preventing or reducing the earnout payments. The buyer will ask that its obligation be subject to only using “commercially reasonable efforts.”
Maximize the earnout. The seller will often ask for an obligation of the buyer to use commercially reasonable efforts to operate the acquired business in a manner that will maximize the earnout payment.
Support. The seller may ask for a covenant that the buyer will provide ongoing financial and other support to the acquired business.
Expenses. If an EBITDA calculation milestone is employed as the earnout mechanism, the seller will ask for a variety of expenses and overhead costs to be excluded from the EBITDA calculation to avoid manipulation by the buyer.
Operation in the ordinary course. The seller may ask that the buyer continue to operate the acquired business in the ordinary course. But buyers want to make sure that they have the flexibility needed to change operations as circumstances warrant it.
Retention of the seller’s management team. As a protective mechanism, the seller may request a commitment that the key management personnel of the acquired business will not be terminated without good cause.
Periodic financial statements and information. The seller will expect to receive periodic financial statements and information relevant to the earnout milestones.
Escrow. The seller may ask that the buyer place in escrow the minimum amount anticipated to be earned via the earnout to ensure payment or improve the seller’s negotiating position in the event of a dispute.

Acceleration of the Earnout Payments

The seller will argue that under certain circumstances, the maximum amount of the earnout should be accelerated and paid out early. The circumstances could include these events during the earnout period:

Sale. A sale or change in control of the buyer or the acquired business.
Breach. A breach by the buyer of any of its covenants/obligations (the buyer will argue that this should be limited to material breaches, or that damages instead of acceleration is the appropriate remedy).
Material change. A material change in the acquired business by the buyer.
Termination. The termination of the key management by the buyer without good cause.
Early achievement. The achievement of financial milestones early (such as a gross revenue milestone being achieved before the end of the year).

Offset Rights Against the Earnout Payments

The earnout provisions may address whether the buyer will have an offset right in the event of indemnification claims against the seller. The seller will strenuously resist such a right and may insist on a specific statement disclaiming any offset rights. The seller will argue that the buyer should look solely to the buyer’s M&A reps and warranties insurance or the escrow indemnity established in the acquisition agreement for recourse on indemnification claims.

How Earnout Disputes Can be Resolved

Since earnout provisions often lead to disputes, the parties should have a clear mechanism for resolving disputes.

A preferred dispute resolution mechanism is confidential binding arbitration in order to avoid long and costly litigation. Here is a sample arbitration clause that can be used:

“Dispute Resolution. The parties hereto agree that any dispute arising out of or in connection with this Agreement shall be resolved solely and exclusively by confidential binding arbitration with the Judicial Arbitration and Mediation Services (“JAMS”) to be governed by JAMS’ Comprehensive Arbitration Rules and Procedures applicable at the time of the commencement of the arbitration (the “JAMS Rules”) and heard before one arbitrator. The parties shall attempt to mutually select the arbitrator. In the event they are unable to mutually agree, the arbitrator shall be selected by the procedures prescribed by the JAMS Rules. The location of the arbitration shall be [city], [state]. Each party will bear its own legal fees and expenses, and 50% of the arbitrator’s fee.”

Sample Earnout Payment Provisions (Based on Gross Revenues and Favorable to the Seller)

Here is a sample earnout section to an acquisition agreement, based on gross revenue milestones, with language favorable to the seller:

“Earnout Payments. In addition to the other payments made pursuant to Section _____ of this Merger Agreement, Parent will make a monthly payment by wire transfer to the Stockholders pro rata to their stock ownership, by the 30th day of each month, commencing with the first full or partial month after the Closing, in an amount equal to __% of the Gross Revenues (the “Earnout Payments”). The Earnout Payment shall be a minimum of $______ per month. The Earnout Payments will continue for a period of three (3) years after the Closing Date (the “Earnout Period”). “Gross Revenues” is hereby defined to mean any and all gross revenues, without deduction of any costs, fees or expenses whatsoever, that are directly or indirectly attributable to or relate to the Company, the surviving corporation pursuant to the acquisition contemplated herein, their business, and any derivative products or services, and whether such items are earned through the Company, Parent or any of their Affiliates.

Information Rights. For each calendar month during the Earnout Period, Parent shall provide to the Stockholders a complete and accurate monthly report, within 30 days after the end of each month, setting forth in reasonable detail the Gross Revenues earned for the month, by category of revenue, and a calculation of the Earnout Payment owed for the month. Parent will provide the Stockholders and their accountant with reasonable access to such books, records, work papers (including outside accountants’ work papers), employees and accountants of Parent and the Surviving Corporation, as the Stockholders may reasonably request in connection with verifying the correct amount of the Earnout Payments that are due and payable.

Obligations of Parent. During the Earnout Period, Parent shall, and shall cause its Affiliates, to use commercially reasonable efforts and act in good faith and fair dealing to maximize the Gross Revenues and devote sufficient and appropriate resources and personnel to maximize the Gross Revenues. Such actions shall include, but not be limited to, promoting the Company’s website and offerings throughout the websites of Parent and its Affiliates and allocating appropriate and sufficient resources to enable the payment of the Earnout Payments. Parent shall not, and shall not authorize or permit its Affiliates to, (i) take any action with the intent of avoiding or reducing the payment of any Earnout Payment, (ii) divert to another business of Parent or its Affiliates any business opportunity in a manner that could reasonably be expected to or does diminish or minimize the Earnout Payments, (iii) take any action for the purpose of shifting Gross Revenues outside of the Earnout Period or (iv) reduce Gross Revenues (including by providing discounts, rebates or other price concessions) in a manner inconsistent with prudent industry practice.

Dispute Resolution. Any disputes regarding Earnout Payments will be handled through confidential binding arbitration pursuant to Section _____ of this Agreement.

Late Payments. Any late payments on Earnout Payments owed shall accrue interest at the rate of 1.5% per month until paid.

No Offset. Parent may not offset or withhold any amounts due hereunder for any reason.

Acceleration of Maximum Earnout Payments. If any of the following events occur, then Parent shall pay the Stockholders within five (5) days thereof $____, which is deemed to be the maximum amount to be earned from the Earnout Payments:

The sale or change in control of the Parent or the sale or change in control of the Company or its business
The material breach by Purchaser of any of its obligations or covenants set forth above
The Company’s current CEO, COO or CTO is terminated by Purchaser without good cause (as defined in their employment agreements)
[Other events desired by seller]

Material Inducement. The provisions of this Section _____ are a material part of this Agreement and a major inducement to the Stockholders agreeing to the Merger.”

Sample Earnout Payment Provisions (Based on EBITDA and Favorable to the Buyer)

Here is sample earnout section to an acquisition agreement, based on EBITDA milestones over three years, with language favorable to the buyer:

“Earnout Payments. Parent shall pay the Earnout Payment to the Company Stockholders, in annual installments in the amounts and upon the conditions as set forth herein below and in such amounts as is set forth in the [Merger Consideration Spreadsheet.] Earnout Payments, or the right to receive Earnout Payments, may not be pledged, assigned or transferred. The obligation to pay the Earnout Payments shall be based upon, post-Closing, the Surviving Corporation (the “Company Business”) achievement of not less than ___% of the applicable EBITDA Targets for each Earnout Period. The Company Business must achieve at least ___% of the EBITDA Target in the year in which it is payable in order to obligate Parent to pay any Earnout Payment for such Earnout Period. Each Earnout Payment that is earned shall result in a payment in the aggregate to the Company Stockholders in such amounts as set forth on the Merger Consideration Spreadsheet. To the extent that ___% or less of the EBITDA Target is met during any Earnout Period, the Company Stockholders shall lose the right to receive any Earnout Payment for such Earnout Period. To the extent that more than ___% but less than 100% of the EBITDA Target is met during any Earnout Period, the Company Stockholders shall receive, on a linear basis, the equivalent percentage of the Earnout Payment for such period, and the Company Stockholders shall lose the right to receive any balance of the Earnout Payment for such period. To the extent that 100% or greater of the EBITDA Target is met during any Earnout Period, the Company Stockholders shall receive the entire Earnout Payment for such period. Within 90 days following the end of each Earnout Period, Parent shall cause the Surviving Corporation to prepare and deliver to the Securityholder Representative a statement of the EBITDA for the Company Business for such prior Earnout Period (each such statement an “EBITDA Statement”). If within thirty (30) days following delivery of the EBITDA Statement, the Securityholder Representative has not delivered to Parent written notice (“EBITDA Objection Notice”) of its objections to the EBITDA Statement (it being agreed that such EBITDA Objection Notice must contain a statement describing in reasonable detail the basis of such objections), then the EBITDA Statement shall be deemed final and conclusive. If the Securityholder Representative delivers the EBITDA Objection Notice within such 30-day period, then Parent and the Securityholder Representative shall endeavor in good faith to resolve the objections, for a period not to exceed 30 days from the date of delivery of the EBITDA Objection Notice. From the Effective Time through the end of the Earnout Period, Parent shall not take any willful action the sole purpose of which is to prevent or reduce generation of EBITDA sufficient to enable payment of the maximum Earnout Payment payable under this Agreement.

For purposes of this Agreement, the following terms have the following respective meanings:

“Earnout Payment” means an aggregate payment to the Company Stockholders in three (3) annual installments if, and only if, the Company Business’ EBITDA meets not less than ___% of the applicable EBITDA Earnout Target. If the Company Business meets ___% or more of the applicable EBITDA Earnout Target, the actual percentage of the EBITDA Earnout Target obtained by the Company Business shall equate to the percentage of the total amount of Earnout Payment due for such Earnout Period up to 100%, in which case the entire amount of the applicable Earnout Payment would be due. Each Earnout Payment installment shall be comprised of cash assuming 100% or more of the applicable Earnout EBITDA Target is met.

“Earnout Periods” means (i) the period commencing on January 1, ___, and ending on December 31, ___, [and] (ii) the period commencing on January 1, ___, and ending on December 31, ___, and (iii) the period commencing on January 1, ___, and ending on December 31, ___.

“EBITDA” means the earnings before interest, income taxes, depreciation and amortization of the Company Business for the applicable fiscal period ended, calculated according to generally accepted accounting principles as consistently applied to Purchaser’s financial statements.

“EBITDA Earnout Targets” means (i) $___ for the period commencing on January 1, ___, and ending on December 31, ___, and (ii) $___ for the period commencing on January 1, ___, and ending on December 31, ___, and (iii) $[___] for the period commencing on January 1, ___, and ending on December 31, ___.”

About the Author

Richard D. Harroch is a Managing Director and Global Head of M&A at VantagePoint Capital Partners, a venture capital fund in the San Francisco area. See all his articles and full bio on AllBusiness.com.