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Private Company M&A - Earn-Outs: Gravy on Top?

This article is part of a continuing series by Frank Jones outlining recurring issues of critical importance to sellers in private company M&A. Previous topics include Equity Rolls, Net Working Capital Purchase Price Adjustments, Indemnification Clauses and Claims and Rep & Warranty Insurance.

Periodically, particularly during economic downturns or times of market uncertainty, the private M&A market experiences a significant increase in the use of earnouts. As was the case following the Great Recession and the economic fallout from COVID, the private M&A market has recently seen a noticeable rise in the use of earnouts as a risk allocation device.

An earnout is a standard provision used in private company M&A to help bridge a valuation gap between Buyers and Sellers. Specifically, an earnout is a contractual provision that makes the payment of a portion of the purchase price contingent upon the post-closing business hitting certain negotiated benchmarks, often based on the Seller’s financial projections. From the Buyer’s perspective, the benefit of an earnout is three-fold — it can help reduce the financial risk of overpaying, it can provide incentives that focus management on achieving specific post-closing goals and it can also serve as a financing vehicle, by allowing a portion of the purchase price to be paid after Closing without taking on additional debt. The downside is that an earnout may reduce the Buyer’s ability to freely integrate, restructure, operate, or re-sell the business or it may create post-closing ill will with continuing executives. While earnouts are typically resisted by Sellers, one benefit to Sellers is obvious — increased purchase price — though they also can broaden the bidder pool and potentially serve as deferral and other tax planning opportunities. 
 
While an earnout in theory can be a “win-win” for both Buyer and Seller, earnouts typically are highly deal-specific and heavily negotiated, as the parties tussle over nuanced issues involving performance metrics, targets, and time periods, post-closing control of budgets, staffing, operations, subsequent M&A, employment and other items. While seemingly an elegant solution to a valuation disconnect, 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 fact, a recent study found that less than 60% of deals with an earnout resulted in either a partial or full payment.

Below is a summary of the key factors a Seller should consider in structuring and agreeing to an earnout in any M&A deal.

What Percentage of the Total Purchase Price?

In a typical lower middle-market M&A deal, the earnout portion of the purchase price usually represents between 15% and 30% of the total purchase price, although this can vary depending on the specific circumstances and level of uncertainty regarding the target company's future performance; in some cases, it could be as high as 50% or more.
 
Performance Metrics and Targets to be Used?
 

• Revenue-based metrics, such as gross revenue, sales, or net revenue?
  • Sellers prefer revenue-based metrics because they are straightforward, less affected by costs and expenses, easier for Seller to control, and more difficult for Buyer to manipulate.

 

• Profit-based metrics, such as net profit, EBITDA, EBIT, and margins?
  • Buyers strongly prefer EBITDA-based metrics as a more reliable indicator of a business's true value and profitability.
  • If EBITDA is used, savvy Sellers will often seek to exclude from its calculation a variety of expenses and overhead costs to lessen possible manipulation by the Buyer.

 

• Gross profit (sales minus cost of goods sold) is sometimes used as a compromise financial metric.

 

• Non-financial metrics, such as achievement of milestones tied to R&D or technical achievements, client acquisition or retention, product launch or market acceptance or regulatory approvals are also sometimes used (particularly for life science companies with a limited operating history), though much less frequently.

 

• Combination or hybrid metrics are also sometimes employed as a compromise.

 

• Key question: Are the metrics and targets used realistically achievable? A lay-up? A roll of the dice? Will the Seller be able to strongly influence, if not control, the variables that drive the selected metrics?

Duration of Earnout Period? Over what period must the metrics be satisfied before the earnout is earned?
 

• 1 to 3 years is typical, though longer periods are not uncommon for smaller deals

 

• Does the metric have to be satisfied on an annual basis or just on a cumulative basis over the full earnout period selected? Catch-up payment if a performance metric is missed in a specific period, but made up for in subsequent periods?

 

• How does the period selected impact the post-closing alignment of interests between the Buyer and Seller? 

 

• Often tied to the period during which Sellers have to remain active in the business.

How are Earnouts Payments Calculated?
 

• Flat or Variable? Though a flat, stated amount is most commonly used, the earnout amount can be variable and set at a multiple of the amount by which the earnout target is exceeded, a percentage of the earnout target specified (a percentage of the EBITDA or other target), or another agreed-to formula.

 

• All or Nothing or Graduated Payments? Is there an absolute floor amount that must be hit before any payment is earned (e.g., a hard target of $10 million in gross profit in 2025), or are the payments graduated (e.g.,  a targeted range of $8 million to $12 million in 2025 gross profit, with partial earnout payments made based on actual gross profit between $8 million and $12 million)?

 

• Minimum or Capped Payments? Some earnouts require a minimum payment in the future, and other earnouts state a maximum payment, particularly for formula-based earnouts.

 

• Revenue Recognition & Accounting Standards 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 own accounting standards?

 

• How to Handle Post-Closing Disputes? Most disputes arise when the parties disagree on how to measure the acquired company’s financial performance. This is often caused by inattentive or vague drafting of the purchase agreement. The purchase agreement should precisely spell out how calculations will be made and how any disputes will be addressed.

 
How Does a Seller Protect Future Possible Earnout Payments? A central area of any earnout deal is the specific “protective provisions” the parties negotiate in the purchase agreement. Key negotiation points and sequencing often include the following:
 

• Specific Control over Key Post-Closing Operational Issues. Some Sellers initially may seek specific controls and protections over a host of post-Closing issues that impact earnout metrics, such as budgeting, staffing, integration, minimum working capital requirements, debt restrictions, product pricing, marketing commitments, and subsequent M&A. Though facially logical to a degree, Buyers rarely agree to such restrictions and insist on retaining very broad discretion over the post-Closing operation of business.

 

• Affirmative Covenant to Operate Business in Ordinary Course, Past Practices & Established Plans. The Seller will then often ask for an obligation from the Buyer that it will operate the acquired business only in accordance with the Seller’s pre-closing operations and stated plans, perhaps as set forth in an existing business plan. As above, Buyers rarely agree to this stating that they cannot be hampered by inflexible restrictions that limit their ability to respond to future industry and business conditions.

 

• Negative Covenant to Not Act to Defeat or Reduce Earnout Payment. The Seller may then seek an obligation that the Buyer at least will not act (or fail to act) for the purpose of (or with the likely effect of) preventing or reducing the earnout payments. Most Buyers resist and promise to only commercially reasonable or other efforts to not take actions intended to reduce earnout payments.

 

• Good Faith and Fair Dealing. At a minimum, the Seller should ask for a Buyer obligation to operate the acquired business in good faith and to deal with it fairly. Although the law of many states imposes these requirements as a settled matter of contract law, there are exceptions and limitations, so this should be affirmatively stated in the purchase agreement.

 

• Periodic Financial Statements & Audit Rights. In any event, the Seller should insist that the Buyer maintain separate books and records for the acquired business and that the Seller receives financial statements and information and audit rights relevant to all time periods and earnout metrics.

 
Obviously, a very real and inherent tension exists between the flexibility a Buyer will insist it needs and the protective provisions that a Seller wants.
 
Form of Earnout Payments?
 

• Settled in cash, securities, or other property?
  • Cash is king and typically insisted upon by Sellers in private deals.

 

• For one-year earnouts, a single payment is typically called for following the end of the year. Earnouts with multi-year periods typically have multiple payment dates throughout the earnout period.

 

• Does the Buyer have the right to offset any earnout payments against other amounts?
  • Sellers argue that the Buyer should look solely to the M&A representations and warranties, the escrow indemnity escrow, and any rep and warranty insurance to satisfy indemnity claims, not the earnout.

   

• Should a third-party escrow be used to secure payment? Is the Buyer a good credit risk?

 
Should Earnout Payments be Accelerated? Possible triggers include these post-closing events during the earnout period:
 

• A subsequent sale or change in control of either the Buyer or the acquired business.

 

• A material or fundamental change by the Buyer in the nature of the acquired business.

 

• Buyer’s failure to retain the key management team (typically limited to termination without cause), though this right may unintentionally convert the payment from contingent purchase price into employee compensation for tax purposes (see Tax & Accounting discussion below).

 

• Buyer’s breach of any of its material obligations to Seller, such as Buyer’s lack of post-closing support or its operation of the business in a way that minimizes or eliminates the earnout payments.

 

• The clear achievement of all earnout metrics before the end of the earnout period.

Tax & Accounting Treatment
 

• Seller’s Tax Treatment
  • If the payment is considered part of the purchase price, then it should be taxed at a capital gain rate.
  • If instead the payment is deemed to be compensation paid to the Seller as an employee, paid otherwise for future services, or under a non-compete, it will generally be taxed as ordinary income and potentially subject to IRS “golden parachute” rules.
  • In most cases, the receiving Seller parties do not pay taxes until earnout payments are actually received. 
    • Assuming the payment meets the IRS requirements for installment sale treatment and the Seller does not elect to treat otherwise, the Seller’s recognition of gain on the earnout payments can generally be tax deferred, subject to special basis recovery rules.
    • If a Seller instead elects not to apply the installment method, the Seller recognizes a gain equal to the “amount realized” on the sale and its basis in the stock. The amount realized includes the current fair market value of the right to receive future earnout payments.

 

• Buyer’s Accounting Treatment Though obviously of more importance to Buyers, Sellers should be aware of the practical implications that the accounting treatment of earnouts pose
  • Under financial accounting standards, Buyers are generally required to initially record potential earn-out payments on their balance sheets as a liability, valued at their present “fair value” on the closing date based on the probability of payout.
  • Changes to this estimated liability amount are re-measured and adjusted throughout the earnout period until all potential earnout payments are made. These modified amounts are adjusted on the balance sheet and recorded as a gain or loss on the Buyer’s income statement.

 
The above drives home the critical importance to Sellers of thorough planning, active negotiation, and careful drafting in considering and agreeing to any earnout arrangement. Consequently, we often advise our sell-side clients at the outset of many deals that earnouts can be a ticket to a post-closing dogfight, may never be paid, and, on some level, should be viewed primarily as “gravy.”

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The above summary has been prepared for general informational purposes only and is not intended as legal advice.  Sellers and Buyers alike are urged to consult their legal counsel concerning any particular situation and specific legal questions.  Counsel should not be selected based on advertising materials, and we recommend that you conduct further investigation when seeking legal representation.

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