Earnouts (Part II): Good For Your Deal?

If you’re in the process of buying or selling a company, there’s a very good chance you’ll be faced with the decision of whether to include an earnout in your deal.  If you talk to people who have used earnouts in past deals, you just might come away with the conclusion that your “decision” should more appropriately be described as a “dilemma.”

“Price” is surely among the most important deal points for you, and reaching agreement on price can be made more challenging by an economic environment in which the Seller’s company is not achieving what it could in a more vibrant economy and the Buyer is in no mood to overpay.  For better or worse (and perhaps more the latter than the former), Buyers and Sellers almost reflexively fall back on an earnout as a way to bridge the gap between a Buyer’s and a Seller’s competing expectations on price.

But is an earnout really the best way for you to resolve a disagreement over price?  Are you tuned in to the pros and cons of using an earnout?

1.  Why Use an Earnout? 

Let’s start with some benefits to using an earnout:

• By bridging the gap between Buyer’s and Seller’s competing expectations on price, an earnout could put the parties in a position to complete a deal that might otherwise have fallen apart.
• If you’re the Buyer, an earnout will help prevent you from overpaying for a business that ends up doing poorly after the purchase is completed.
• Because Buyer will not need as much cash at closing to complete the deal, Buyer may be able to avoid the costs and risks of taking on new debt to pay for the Seller’s business.
• If you’re the Seller and the business performs exceptionally well post-sale, you may be entitled to receive a much higher total sale price than you’d originally expected.

2.  Why Avoid an Earnout?

All too frequently, though, Buyers and Sellers ignore or discount the potential risks and costs associated with using an earnout in their deals.  Here are some (but certainly not all) of the downsides of using an earnout:

• Negotiating an earnout can add substantial cost and delay to the process of getting your purchase agreement finalized and signed.  For more complicated or heavily negotiated earnouts, your legal fee could be 20-30% higher than it would have been without the earnout, and negotiating the earnout could add weeks to the process.  Are these extra costs and delays worth it to you?
• Structuring an earnout can involve complex tax and accounting issues, which in turn will drive up your professional fees.
• Earnouts are frequently litigated.  Often, disputes arise when Seller believes Buyer has either miscalculated the business’s post-sale performance or not done the things necessary to the achievement of the milestones upon which Seller’s earnout payments are based.
• Seller will want Buyer to do at least two things: (i) maximize short-term business performance, and (ii) conduct operations in a way that maximizes the earnout payments required to be made to Seller.  As such, Seller will negotiate for rights that allow it some control over Buyer’s operation of the post-sale business.  But what Buyer wants to leave any control at all in the hands of Seller, after having paid Seller dearly to acquire the business?   And can Seller ever reasonably expect to control Buyer’s business decisions when Buyer’s long-term plans are inconsistent with Seller’s short-term goals of maximizing the earnout payments?

There are certainly other drawbacks to using earnouts, but suffice it to say that earnouts are not appropriate in all deals and may truly be the wrong approach in some deals.  Far from being a panacea, earnouts can end up saddling you with costs, delays, and even litigation, particularly if the earnout is not carefully negotiated and drafted.  If you’re struggling with whether to use an earnout in your deal, consider the points made above and, more importantly, work with your lawyer to understand whether it’s really right or even necessary in your deal.