An earnout is a pricing mechanism in a merger and acquisition (“M&A”) transaction whereby a purchaser will make a payment to the seller upon the target business being acquired having met some pre-agreed metrics relating to its financial or operational performance after completion. In this article, one of a multi-part series on M&A, we examine some of the issues which a seller and a purchaser may wish to consider when structuring an earnout in a purchase and sale agreement. In other articles, we look at a range of issues including the use of a letter of intent in an M&A transaction, due diligence and representations and warranties, financial assistance for the purchase of shares, and the key terms of an asset purchase agreement and a share purchase agreement. Readers who may be contemplating an M&A transaction may contact our M&A lawyers for more specific information tailored to their individual circumstances.
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In M&A transactions, sellers and purchasers often have different views on the value of a target business and hence, different views on how the target should be priced. Not uncommonly, a seller may be more confident about the business prospects of the target and will seek a higher purchase price to reflect its optimism for future growth. On the other hand, a purchaser is not infrequently more conservative about such prospects and will seek a lower price to minimize the risk of any overpayment.
What is an Earnout?
An earnout is a methodology for pricing an M&A deal which is commonly used to bridge valuation gaps between the seller and the purchaser. It is a payment mechanism whereby the purchaser will, after completion, pay to the seller an additional purchase price (known as an “earnout payment” or simply “earnout” or “earn-out”) upon the satisfaction of pre-agreed conditions. These conditions aim to tie the total consideration paid by the purchaser to the seller to the post-completion performance of the target business. Earnouts are often payable subject to the fulfilment of some financial or operational goals, such as the target business meeting minimum levels of revenues, profits, or EBITDA (earnings before interest, taxes, depreciation and amortization) or other financial or production thresholds within a specified time period after the M&A deal has completed.
Performance Metrics
A key component in structuring an earnout is to define the performance metrics which will be used to determine whether an earnout is payable.
Financial Metrics
Sellers generally prefer revenue-based metrics so that earnouts will be payable regardless of the level of the expenses incurred by the target business under the purchaser’s management. On the other hand, purchasers generally prefer earnings-based metrics which, for example, might prevent the sellers from benefitting from low profit margin projects which drive up revenue but translate little into overall profitability.
Non-financial Metrics
Non-financial metrics may be adopted either in lieu of or in addition to financial metrics. Non-financial metrics may be suitable when the target business is an emerging business with little historical information which can be used as a baseline for comparing financial performance. Common non-financial metrics include the target business hitting certain production target (common for manufacturing businesses), obtaining certain regulatory approvals (common for businesses in highly regulated industries), and securing or completing certain key projects or contracts.
Payment Structure & Milestones
Earnouts can be structured in various ways. Some possible forms are set out below.
“All or Nothing” Binary Payment
Earnouts can be structured on an “all or nothing” basis, meaning the seller receives a lump sum upon the achievement of a pre-defined target but otherwise receives nothing.
Graduated Variable Payment
Earnouts can be structured so that amounts are payable from time to time, whether in fixed or variable amounts. For example, the parties may structure an earnout so that the seller receives an amount each year provided that a financial threshold (say an EBITDA threshold) is met that year. This amount can be fixed or it can be calculated with reference to the extent by which the threshold is exceeded (say 5% of any amount exceeding the threshold). In a more complex form, the amount may include a catch-up amount so that the seller can recoup any shortfall from the threshold in one earnout period by the surplus over the threshold in another period.
Caps and Floors
Earnouts can include caps and floors. These are common in cases where earnouts are payable in variable amounts. For example, because the amount payable could become substantial if a target business were to significantly out-perform initial expectations, a purchaser might wish to cap the aggregate earnout payable. On the other hand, a seller who is concerned that the target business might not be managed in a way which would otherwise unleash its full potential post-completion might wish to negotiate a minimum earnout floor.
Benefits of an Earnout for a Buyer
For the purchaser, earnouts can provide several benefits. One benefit of earnouts for a purchaser is that an earnout helps ensure that the ultimate purchase price will be based on the target company’s actual performance post-completion rather than its projected performance. This enables the purchaser to shift some post-closing risks to the seller. This may be particularly desirable where the target business is a start-up or an emerging business with limited track record.
Another benefit of earnouts for a purchaser is that an earnout can help manage cash flow. Instead of having to make full payment of the purchase price upon completion, an earnout allows the purchaser to defer payment of part of the purchase price.
Risks of an Earnout for a Seller
A typical seller will want to receive the full amount of the purchase price at completion. Where the seller accepts deferred payment in the form of an earnout, the seller may wish to take measures to address the following:
Buyer Credit Risk – In any earnout, to some degree, the seller will be assuming the purchaser’s credit risk. Ownership of the target business will have passed to the purchaser without the seller having received full consideration and it is possible that the purchaser will either dispute the earnout or fail to pay it.
Buyer Performance Risk – As an earnout is tied to the performance of the target business after the buyer takes over ownership, the seller’s entitlement to an earnout will, to some degree, depend upon how the buyer operates the business.
Post-Completion Restrictions
Given this latter risk, a seller will typically seek some degree of control and oversight over the target business post-completion to protect its economic interests. In this regard, it is not uncommon for the seller to impose restrictions on how the target business should be operated, not only to set boundaries on expectations as to how the business may be operated but also to prevent potential manipulation of financial or operational metrics by the purchaser. A key concern for a purchaser is whether these restrictions might unduly restrict its ability to run the business as it sees fit.
Operational Consistency
Most commonly, a seller will seek a covenant requiring that the target business carry on its business in the ordinary course as it has been carried on before. A purchaser may resist such a covenant as it could, for example, limit the purchaser from undertaking new business activities which may underlie the commercial case for the acquisition and would limit the purchaser’s flexibility should it wish to make changes to protect its investment in the target business in response to changing business conditions.
Extraordinary Items
A related concern for a seller is the target business under the purchaser’s management incurring higher expenses. Though these expenses may be of the same type that the business incurred in the past, the amount of these expenses may be higher. Such expenses may, for example, include higher bonus payments or higher salaries for new staff brought in by the purchaser to replace old staff. Given this concern, the seller may wish to specify clearly what items will be included in the calculations and what will be excluded.
Change of Control
Earnouts are contractual provisions which typically only bind the purchaser to the earnout. If the purchaser onward sells the target business to a third party before the seller has received its earnout in full, the new owner will not be bound to the earnout and the seller will be unable to assess whether earnout metrics have been satisfied. As a result, the seller may wish to accelerate payment of the earnout upon a change of control of the target business, meaning the purchaser would need to pay all or some of the earnout amounts before the metrics that are intended to be reached are in fact reached. Not surprisingly, a purchaser will wish to resist as, for example, it may wish to exit its investment in the target business as a result of its underperformance.
Affiliate Transactions
A risk for a seller is a purchaser causing the target business to deal with the purchaser or one of its affiliates through non-arm’s length transactions, hence preventing the target business from meeting a performance threshold. A seller may wish to pre-empt this risk by prohibiting the purchaser from transacting with an affiliate without the seller’s prior consent. A purchaser may resist such a prohibition on the basis that it wishes to consolidate the target business into its corporate group so as to obtain synergies.
Non-Arm’s Length Transactions
A related risk for a seller is the purchaser causing the target business to deal on non-arm’s length terms. For example, the purchaser may allocate higher costs to the target business in relation to dealings with a supplier to obtain lower costs for an affiliate from the same supplier. As a result, the seller may wish to specify certain price ranges (e.g. with reference to industry-specific guides or indicators) within which the target business must transact in order to manage the risk of undervalued revenues or overvalued expenses.
Access to Information
A seller will usually seek to impose on a purchaser obligations to provide audited accounts and other information during the earnout period to enable it to monitor the performance of the target business post-completion and determine its earnout entitlement. At the same time, the purchaser will seek to ensure that any information provided to the seller will not be misused.