Understanding Earnout Agreements in M&A Transactions

ByDavid Moore

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An earnout is the mechanism whereby valuation gaps are bridged between buyers and sellers in mergers and acquisitions. The agreement ties part of the purchase price to future performance by the target company. Earnouts provide a flexible solution that aligns goals across parties while ensuring a smooth transaction, accounting for uncertainties. In this article, we will discuss what earnout agreements are, the key considerations involved, and how they work in M&A transactions.

What is Earnout Agreements?

An earnout provision is a contractual arrangement in M&A transactions whereby the full price paid for acquiring a firm hinges on its subsequent performance by the acquired company. He shall pay no upfront money towards the full price as agreed on; instead, he shall pay the seller additional sums based on the acquiring company’s ability to hit specific financial or operational milestones after acquiring the firm.

This is a very common scenario where the earnout is useful in that the buyer and seller have different outlooks concerning the value of the company. The seller may think that the company has tremendous growth potential, but the buyer may be very concerned about overpayment in case the company fails. The difference is, therefore, smoothed out by the earnout agreements where part of the payment is contingent upon performance.

Common Situations Where Earnout Agreements are Used

  • Startups and Growth Companies: Earnouts are often used in deals that involve startups or growth companies where future success is uncertain.
  • Strategic Acquisitions: For acquisitions where the value that is derived from the acquired company depends largely on its performance post-acquisition-for example, launching new products or expanding into new markets.
  • Disagreements on Valuation: When the buyer and seller cannot agree on the value of the company, the earnout can bridge the gap by deferring part of the payment until performance proves that the company is worth.

Key Considerations in Earnout Agreements

Although earnouts may offer a degree of flexibility, they equally offer complexities requiring careful legal and strategic planning. There are many considerations that must be addressed to ensure the earnout is structured properly.

Performance Metrics

The basis for an earnout arrangement is how performance is measured for additional payment date. The metrics should be measurable, clear, and in line with the objectives of both parties. Commonly used metrics include

  1. Revenue Targets: The firm shall generate certain revenue levels that have been put forward.
  2. EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization): Often used to assess profitability but also operating efficiency.
  3. Customer growth: This is a metric that applies specifically to subscription-based companies, which measures customer acquisition or retention.

Time Frame

This brings in the earnout period, which is also one of the crucial elements for an earnout agreement. Normally, the earnout term is between one and five years, but depends on the type of business involved and growth prospects.

  1. Short-term earnouts: This is 12-24 months of structure and works better where quick performance improvements are possible.
  2. Long-Term Earnouts: Three to five years or more, and which is very common in most industries in which there exist high investments or long product development periods.

Control & Management Rights

Another recurring issue in earnouts is how much sellers are allowed to continue making business decisions after the acquisition. Sellers want things to remain exactly as they have always been, while buyers want streamlined operations. Sellers’ earnings are tied to the company’s performance, so things cannot remain the same.

  1. Seller retains control: The seller still maintains the ownership of the company post acquisition, therefore, sometimes they can be able to attain some earnout objectives.
  2. Buyer Takeover Control: The earnout deal should provide safeguards against those decisions of the buyer that will adversely affect the seller from achieving the performance targets while the buyer is in control.

Dispute Resolution Mechanisms

It is extremely probable that disagreements arise over meeting performance targets or over the way metrics are calculated. For this reason, mechanisms for dispute resolution should be clearly specified in an earnout agreement, including mechanisms for dispute resolution, for example:

  1. Independent Auditors: Independent auditors can be hired third party to check the financial performance, and hence the accuracy of the reports.
  2. Arbitration Clauses: Arbitration is relatively speedier and less expensive compared to litigation as a dispute resolution mechanism.

 

Well-defined processes for dispute handling can help avoid long legal battles and keep the focus on the long-term goals of the transaction. For those interested in deepening their knowledge in this area, corporate law courses, business law courses, or law certification courses can be very helpful in structuring such agreements.

How Earnout Works in M&A Transactions

Earnout agreements operate as deferred payment structures where the buyer agrees to make future payments contingent on the company achieving certain performance milestones. Here’s how the process typically works:

Payment Structure

The payment under earnout agreement is split into two dominant components:

  1. Upfront payment, This is the amount paid upfront for the purchase price at the time of acquisition. It thus offers some immediate liquidity to the seller.
  2. Deferred Payment, The remaining purchase price is then paid over time, but pending the fulfillment of the predetermined performance metrics by the company.

Tracking & Monitoring Performance

Once the earnout is set up, the performance of the company will be monitored on the metrics outlined in the agreement. The management team and other external auditors will ensure that:

  1. All the financial metrics, such as revenue and EBITDA, are correctly reported.
  2. For instance, customer retention is closely monitored as an operational goal.

Adjustments & Contingencies

Typically, earnout agreements have clauses which account for changed circumstances which may affect the ability of the company to meet its targets. Some of them include:

  1. Force Majeure Clauses: It also includes force majeure clauses to protect both parties involved in the contract from unforeseen events, such as economic downturns, natural disasters, or pandemics.
  2. Adjustments for External Factors: The contract can have provisions for adjustments in case the environmental factors outside the control of the company affect performance.

Final Payment

When the earnout period is nearing its end, the buyer determines whether the performance metric was met. If performance was met, then the payment is made to the seller; Pursue Law certification courses to know more the this. however, if performance was not met, then there may be a reduced payment, or no payment at all might be made to the seller.

Conclusion

Earnout agreements remain a useful tool in M&A transactions. They bridge gaps in valuation between buyers and sellers while at the same time enabling the buyer to incentivize future performance by the seller and its management. They remain complex, however, and can only be successfully executed upon careful legal planning and well-structured strategy. That is when clear performance metrics, a well-defined time frame, and balanced control of management decisions are set down. For professionals interested in the legal and financial aspect of mastering M&A deals, especially earnouts, courses in corporate law, business law, and courses in law certification are necessary.