Know What You Are Getting With an Earnout

Employment - Know What You Are Getting With an Earnout

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A Guide To Structuring An Earnout

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Employment

"Experience is what you get when you don't get what you want." - Dan Stanford

Before one digs deep into the structure of the earnout it is important to understand the motivation of the parties in structuring the earnout. Is the purpose of the earnout to bridge a valuation gap based on legitimate differences of idea about the number of time to come earning streams? Does the earnout have to do more with possible business transferability issues? Is the earnout primarily about creating incentive for delivering high performance?

Historically, earnouts have been used by M&A advisors to bridge a valuation gap in the middle of the seller and the buyer. Sellers typically tend to value their business much higher than a buyer and an earnout can be great way to satisfy both parties. Astute acquirers have also used earnouts to incentivize and motivate sellers to deliver on a operation promise post close.

The above reasoning has changed significantly in the up-to-date past. The retreat and reputation crisis have put the acquirers in the catbird seat and acquirers are demanding earnouts primarily as a negotiating lever - sometimes in situations where none would be warranted by historical precedents.

The structuring and negotiating of the earnouts should be based on a clear insight of the motives. Regardless of the motives, all earnouts have any key components:

Duration of the earnout: Most earnouts last in the middle of one and three years. Anything shorter than a year is typically meaningless to the acquirer. In most cases, duration longer than three years significantly increases the opportunity of unforeseen events impacting the business and makes projections used for earnout unrealistic. To the extent used, longer term earnouts need to be written to decrease the uncertainty and reduce the possible risks.

Identification of milestones: Milestones for earnouts can be financial or non-financial. For financial earnouts, sellers typically prefer wage based milestones because they are easier to achieve and monitor. On the other hand, acquirers prefer net wage based milestones because wage based incentives may motivate the sellers to drive wage at the expense of profitability. An Ebit or Ebitda based milestone can often furnish a good compromise in the middle of a buyer's and seller's needs. To reach a total agreement, acquirers and sellers should clearly understand the factors effecting Ebit/Ebitda, along with the pre and post close accounting methods used to compute the milestones.

Operation of the business while earnout period: The goals of the acquirer and the operation of the business post-acquisition could be substantially different from the seller's goals and the pre-acquisition operational model. For the earnouts to be meaningful, the acquired business should be operated in a predictable way that, among other things, reduces mismanagement and malfeasance on the part of both the acquirer and the seller. Employment agreements should also be put in place to ensure the seller has a say over relevant operate issues. The earnout may also be adversely impacted by how the acquiring business allocates operational overhead and other expenses in the earnout calculations. A merger or acquisition of the acquiring business or the acquiring division, or a divestiture of the agency or a product line, could also originate situations where the earnout metrics come to be meaningless. It is imperative that the earnout document comprise clauses detailing operational, accounting, and employment specifics and identifying conditions under which the earnout may have to be modified or accelerated.

Establishing if/when milestones are achieved: Typically it is the acquirer's responsibility to identify when an earnout milestone is achieved and furnish the calculations pertinent to the earnout. A prudent seller should ensure that he has entrance to audited/auditable books that characterize to the earnout calculations should a dispute arise. The parties also need to develop mechanisms to deal with any challenges to the earnout calculations.

Method of payment: An earnout may be paid in cash, stocks, bonds or other securities. If the cost is made in forms other than cash, the seller needs to be cognizant of the possible variability in the cost stream. The acquirer may offer 10,000 shares of the company's publicly traded stock at a stock price of at the time of the deal and unanticipated events could result in the stock price being on the day of the earnout cost - effectively driving the value of the earnout to 1/10th of the anticipated value. Earnouts paid in incommunicable business securities could be even more of a challenge as they are illiquid and are more authentically subject to manipulation.

Tax impact: The earnout language should be drafted meticulously to ensure permissible tax rehabilitation of the earnout. Depending on how the earnout is written, the payments could be capital gains, payroll wage or independent contractor wage - all with very different tax implications. It is imperative that the language be thought about addressed to avoid disagreement and to reduce the tax bite.

Summary:

Earnouts, no matter how well crafted, can comprise pitfalls for both sellers and acquirers. Parities to an earnout agreement must understand each other's motives and craft an operationally workable win-win agreement that reduces scope for possible disagreement and litigation. It is imperative that both parties know what they are getting themselves into with an earnout agreement.

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