A flexible provision raises questions for buyers and sellers alike.
Given the uncertain economic climate of 2023, parties are increasingly turning to earnouts to bridge valuation gaps. As shown by Goodwin’s Private Equity Deal Database (see chart below), there is a clear upward trend in the inclusion of earnouts in acquisition agreements for transactions worth less than $250 million, increasing from 15.4% in 2020 to 30.2% in 2022. In this article, we will explore the definition of an earnout, its key features, and what deal practitioners should be aware of when using an earnout as part of their dealmaking toolkit.
What Is an Earnout?
An earnout is an agreement between a buyer and a seller of a business pursuant to which the buyer agrees to pay post-closing additional consideration for the business in the event that certain milestones are achieved. An earnout is typically used in circumstances in which the parties cannot reach an agreement on valuation and is a means to bridge the gap in such valuation.
Key Features of an Earnout
Earnouts are highly flexible, allowing the parties to craft whatever mechanism they see fit to get the deal done; as such, there is no typical earnout provision. However, there are some common features that deal practitioners should be aware of:
- Performance metric. Each earnout will include a performance metric that, if achieved, results in the payment of the earnout. The performance metric is fact specific but is often tied to a financial metric such as the achievement of certain revenue or EBITDA targets. It can also be nonfinancial, such as the awarding of a contract or granting of a government approval.
- Measuring period and payout structure. The earnout must be tied to a specific earnout period (for example, the fiscal year following the closing). In addition, an earnout can be paid in one lump sum or in multiple tranches over the duration of the measuring period. What the parties ultimately land on is fact specific but is often driven by the nature of the underlying business.
- Control of business subject to earnout. One of the most hotly contested provisions of an earnout will be the conditions governing the control of the business during the measuring period of the earnout. Sellers want assurances that the business will be operated in a manner that will maximize the chances that the earnout milestone will be hit. Buyers don’t want to be overtly restricted in how they run the business post-closing. Reconciling these competing interests can lead to complexity in both negotiating the applicable earnout provisions and compliance with the provisions during the measuring period.
- Other considerations. Another often-negotiated provision is the right of setoff, pursuant to which a buyer has the right to reduce the amount of any earnout payment due to a seller by the amount of any other claim a buyer may have under the acquisition agreement (for example, pursuant to an indemnity). In addition, parties should be aware of the tax and accounting treatment of their earnout.
Deal Practitioner Considerations
In a climate of economic uncertainty, an earnout can reduce risk to a buyer that a business may not perform in the future by deferring the payment of a portion of the purchase price and making it contingent on the achievement of a metric that makes sense to the buyer. An earnout is highly flexible, but the inclusion of such a provision in the acquisition agreement comes at a cost of complexity in drafting, monitoring ongoing compliance, and the opening up of potential disputes. Given the trend of the increased inclusion of earnout provisions in acquisition agreements, a trend we would expect to continue in 2023, deal practitioners would be best advised to think about what performance metric makes sense in the context of the business. For the benefit of all parties, illustrative examples should be attached to the acquisition agreement to minimize any disconnect on the application of what are often complicated earnout mechanics.
Liam F. TimoneyPartner