Earnouts (Part III): Key Negotiation Points

If you’re in the process of buying or selling a company, and you’ve decided or agreed to include an earnout in your deal, your next step is to determine the key terms of the earnout based on the outcome you’d like to achieve.  Being proactive about this (somewhat challenging) task will put you in position to negotiate the best possible deal for yourself.

So, where to begin?  As mentioned in my prior post, earnouts can be complicated and involve complex tax, accounting, and legal issues.  Rather than get bogged down in a long discussion of those complexities, let’s instead explore some of the less complex, often-negotiated points (and leave the complexities to your legal and financial advisors).

Typically, an earnout is paid upon the accomplishment of one or a series of benchmarks during the earnout period, so it is not surprising that many key negotiation points relate to the timing and calculation of the earnout payments and the control of the target business after the sale.  Here is a sampling of some of those key negotiation points:

1.  Duration of Earnout Period.  How long will the earnout period be?  Typically, Seller will prefer a shorter period so it gets paid sooner; whereas, Buyer will usually prefer a longer period so it has more time to make any required payments.  In some situations, however, the parties’ preferences will be reversed.  For example, if Seller will be taking a post-sale management role in the target business and will benefit substantially if the business performance exceeds expectations, Seller may prefer a longer earnout period.  Likewise, if the agreed-upon terms impose significant restrictions on Buyer’s post-sale operation of the target business, Buyer may prefer a shorter earnout period.

2.  Types of Benchmarks.  Will the benchmarks be financial (e.g., the target business’s achievement of gross revenue, earnings, or net income targets), non-financial (e.g., receipt of some governmental license or regulatory approval, or a specified number of hits on the target business’s website), or a mixture of both?

3.  Measurement of Benchmark.  How will the benchmark criteria be measured or determined?  For example, if EBITDA will be used to measure an earnings benchmark, will anything be excluded, included, or adjusted in determining earnings for this purpose?  If the benchmark is the receipt of regulatory approval of some sort, what if the approval is conditional or partial?

4.  Number of Payments.  Will the Seller be entitled to just a single earnout payment made at the end of the earnout period or will there be multiple payments made at intervals during the earnout period?  For example, payments could be made at several intervals, based on the target business’s achievement of EBITDA benchmarks.  Using this example, if the target business’s EBITDA at the first interval far exceeds the applicable benchmark, can the excess be applied to subsequent intervals?  If Buyer paid Seller a premium for that excess EBITDA at the end of the first interval, but the business drastically underperforms in the subsequent intervals, can Buyer “clawback” any previous amounts that are deemed to be overpayments?

5.  Limits on Payment Amount.  Will there be any caps or other limits on the amount that Seller can receive through the earnout?  Buyer may generally prefer the certainty that comes with setting a maximum amount that Seller will be entitled to receive, particularly if Seller will not be involved in operating the target business after the sale.  On the other hand, if Seller will remain involved in the target business, the absence of a cap could create significant “upside” for Seller that will incentivize Seller to maximize the business’s post-sale performance for the benefit of both Buyer and Seller.

6.  Early Termination and Acceleration Upon Subsequent Sale.  If Buyer later wants to sell the target business, will Seller be entitled to an accelerated earnout payment?  If so, how will the amount of that payment be calculated?  Buyer may want to calculate any such payment based on the probability that the remaining benchmarks can be achieved, whereas Seller may reasonably demand that Buyer pay the maximum possible earnout amount as a condition to terminating the earnout.

7.  Resolution of Disagreements.  If there is a disagreement about whether a benchmark was achieved or correctly measured, how will that disagreement be resolved?  The parties could engage independent accountants to resolve financial issues, submit to binding arbitration, or even give Buyer the right to buy out the earnout through a one-time payment to Seller.

8.  Control of the Business.  Saving the best and probably toughest issue for last, how much control will Seller have over the target business after the sale?  Seller will want to maximize its control of the business in the short term to increase the probability that the earnout benchmarks will be achieved as quickly as possible.  Buyer, on the other hand, will resist giving up control over a business for which it paid dearly, and certainly won’t want to sacrifice the long-term prospects of the target business just because Seller’s earnout payments are tied to the business’s short-term success.

So, armed with that battery of considerations, what terms do you think your earnout should have?  And what can your legal and financial advisors tell you about the tax, accounting, and legal ramifications of the earnout terms you think you need?

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