Earnouts: How They May be Strategically Utilized by Independent Sponsors

Earnouts have traditionally been a way for the buyer to offset immediate risk in a transaction by making a portion of the purchase price contingent on any number of metrics, while allowing the seller to participate in the future upside. Global events, such as the COVID-19 pandemic and resulting supply-chain issues, as well as inflation and recent legislative gridlock, have contributed to uncertainty in a variety of industries. For an independent sponsor, this uncertainty has made more difficult the already challenging task of predicting the earnings and future performance of a target business. With the pandemic continuing to cause significant uncertainty in the private acquisition market, parties may increasingly rely on earnouts to bridge the valuation gap and reallocate risk when completing a transaction.

Independent sponsors should be aware that earnout provisions may be available to them as a deal mechanism, but should be mindful of the various issues and tradeoffs in connection with earnouts. In general, earnouts must provide a clear set of responsibilities and contractual protections to ensure that (x) certain interests are represented and (y) future disputes are avoided.

How Are Earnouts Measured?

Earnouts can be tied to a multitude of financial and/or non-financial metrics or events; generally, if an incentive can be measured, then it can be structured into an earnout. The following is a short list of examples that can be used to measure earnouts:

• pre-tax earnings;
• EBITDA;
• gross profit revenue;
• employee retention; and/or
• customer retention.

The Buyer’s Perspective

Earnouts are a useful way for any buyer, and particularly a sponsor, to hedge against macroeconomic uncertainties that might impact a target company’s future growth. By tying the price of the business to future performance metrics, independent sponsors attempt to mitigate the risk of overpaying at closing. The same logic holds true when a target company has a limited operating history, in order to mitigate the buyer’s concerns about the target company’s ability to scale or retain customers after the closing of the transaction. Reducing an independent sponsor’s initial cash payment provides an additional potential advantage to deploying an earnout.

However, despite the foregoing benefits, an earnout does present certain potential risks for buyers. For example, the purchase price may be higher if an earnout is in fact achieved. In addition, in deals where the seller will continue to run the target business, there may be a risk that the seller’s short-term earnout targets may undermine the buyer’s long-term goals; therefore, it is important to carefully negotiate operating covenants with respect to the earnout.

Structuring Earnouts

The challenge in crafting an earnout is balancing the parties’ competing priorities and incentives. Earnout targets should be objective, measurable, and clearly defined in the purchase agreement. The following are some of the main considerations that should be addressed when structuring an earnout:

1. THE SELECTION OF THE TARGET METRIC.
   Often, sellers prefer revenue-based targets due to decreased chances of manipulation, while buyers (x) prefer net income-based targets and (y) are resistant to revenue-based targets if the seller maintains control of the operation (especially given that the seller may not be motivated to reduce expenses). In addition, targets are sometimes non-financial milestones or events, such as the passage of specific legislation, the winning grant of FDA approval, or the successful development of a new product.
2. THE SELECTION OF APPROPRIATE ACCOUNTING MEASUREMENTS AND STANDARDS
   Disputes often arise when the seller believes that the buyer has manipulated the measurement of target performance, or when there is a disagreement over the target’s calculation of performance. Thus, an earnout provision should clearly outline the procedures for calculating a specific earnout target. Specifically, in order to reduce the chance of a future dispute, parties should always choose an accounting method that provides an apples-to-apples comparison between the pre-closing and the post-closing performance of the business.
3. THE DETERMINATION OF THE EARNOUT PERIOD
   Earnout periods are typically tied to a duration period of one to five years, with an average of three years. When considering the length of an earnout period, buyers typically prefer shorter periods because they want to limit the amount of time they are subject to restrictions. Conversely, sellers typically prefer longer earnout periods because they give the buyer more time to achieve targets and increase payment.
4. POST-CLOSING OPERATION
   It is important for parties to address how post-closing acquisition controls will be allocated between the buyer and the seller, and what level of support (if any) the buyer will be obligated to provide to the acquired business if the seller retains control. In deals where the buyer takes over operational control post-closing, the seller will often want a restrictive covenant requiring the buyer to operate the business in a manner consistent with pre-closing operations. In a deal structure where the seller is no longer involved in the business, the seller will want an audit covenant that will guarantee access to the books and records of the company. Further to this point, a well drafted audit covenant will have penalties associated with underreporting or false reporting.
5. DISPUTES AND RESOLUTION
   Post-closing disputes often arise when there are allegations that an acquired business was operated in such a way as to manipulate the earnout payment. Delaware courts generally interpret earnouts using the plain language of the agreement, and, in the, past, have not come to aid sophisticated parties that failed to incorporate certain contractual protections. Delaware courts have also held that buyers do not have a duty to maximize an earnout payment, but rather only to operate the business in good faith. In order to address the forgoing concerns, parties often agree upon an independent third-party accounting firm to handle financial disputes and may wish to consider arbitration as an alternative to litigation.

If you have any questions about this alert do not hesitate to reach out to Paul Marino (Partner – Head of the Corporate Group) at 212.573.8158 or via email at pmarino@sadis.com, or to Edward McNelis (Law Clerk) at 212.573.8151 or via email at emcnelis@sadis.com.