Transaction Advisory

Earn-out provisions require careful planning

This article examines the challenges surrounding earnout provisions, particularly when the subject entity has a short history, but high growth potential, such as in untested technology. Carefully constructed earnout contingencies may help alleviate disagreements between the transaction parties and avoid valuation disparities in the process.

Earn-out provisions

Earnout provisions are often utilized in merger and acquisition (M&A) transactions to bridge gaps between sellers and buyers.  For example, when the buyer cannot justify paying more than $45 million for the subject entity and the seller will not settle for less than $50 million, a carefully structured earnout contingency may help delay, and possibly relieve, the disagreement. The valuation disparity may be broadened when the subject entity has a relatively short operating history, but high growth prospects, perhaps possessing proprietary, albeit unproven technology, and may also be subject to earnings volatility.

An earnout provision enables the seller of a business entity to receive additional compensation, post-transaction, based on the business achieving certain future performance-based goals (e.g., earnings before interest, taxes, depreciation, and amortization (EBITDA); sales or revenues; successful FDA formulation approval; new product launch, etc.).  Quite often, the performance benchmarks must be achieved within a predefined period of time.  If they are not achieved, the contingent payments are reduced or eliminated altogether. Although the terms of earnouts may vary, they generally share several common features related to payment, including: (1) contingent nature; (2) delayed timing; (3) amount variability; and (4) performance-based determinant.

Buyers benefit from the protection afforded by earnouts. They are able to spread the purchase price payment over a protracted period of time and pay a price that more accurately reflects the value of the subject entity.  It also enables the buyer to share performance risk with the seller, ensuring the seller remains motivated, particularly as part of the post-transaction management team. If performance benchmarks are met, the seller benefits from an increased purchase price, validating pre-transaction confidence about management strength, technological advances, product viability, synergistic benefits, etc. 

Despite the appeasement they ideally create down the road, earnouts can also fuel disagreements between the transaction parties.  Earnout provisions should be carefully structured and documented at the time of the transaction; however, it is difficult to predict every contingency.  How should performance be measured?  What type of performance monitoring must occur?  What is the tax and accounting treatment of any contingent payment?  What are the parties’ responsibilities to fulfill performance obligations? When the earnout measurement period lapses and calculations are performed to determine payment, the parties may disagree as to whether the applicable targets for an earnout payment were satisfied. I f they were not satisfied, the parties may also disagree about why the earnout targets were not met.  The Delaware Court of Chancery wrote, “[e]arn-outs frequently give rise to disputes, and prudent parties contract for mechanisms to resolve those disputes efficiently and effectively.” Aveta, Inc. v. Bengoa, 986 A.2d 1166, 1173 (Del. Ch. 2009).

Therefore, to set forth the contractual language of the earnout provision, both parties must be mindful of the features stated above that ultimately impact payment. The benchmark performance metric should be easily quantifiable and unsusceptible to manipulation or differences in interpretation.  The agreement should further specify the post-transaction responsibilities of, and resources to be devoted by, both the seller and the buyer.  Practical numerical examples shown in the agreement may go a long way toward alleviating disagreement upon settlement.

Given the often adverse nature of transaction structuring and earnout negotiating, retention of qualified outside advisors (e.g., attorneys, investment bankers, tax and financial reporting accountants, valuation specialists and other professionals) at the onset will help mitigate the possibility of a disagreement between the buyer and seller while allowing both parties to focus on more immediate integration needs. Furthermore, agreeing to again retain professional assistance at the time the earnout period lapses will increase the likelihood the calculation is performed objectively.

This article was originally written by Adrian Loud and published on the website of Bennett Thrasher, an Atlanta-based, full-service, certified public accounting and consulting firm.  You can reach Adrian at aloud@btcpa.net or (770) 396.2200. 

[author] [author_image timthumb=’on’]http://m.c.lnkd.licdn.com/mpr/mpr/shrink_200_200/p/2/000/0fd/000/221a926.jpg[/author_image] [author_info]Adrian Loud is a shareholder in the Valuation and Litigation Support Services department of Bennett Thrasher.  He has worked with clients across many industries and at various stages in their life cycle.  His experience includes valuation advisory and litigation support services for engagements such as estate tax planning and compliance, economic damages calculations, transfer pricing, financial reporting, employee stock ownership plans, reasonable compensation studies, 409A compliance, condemnation matters and intangible asset and intellectual property analyses.[/author_info] [/author]