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Structuring Earnouts in M&A Transactions

—RMZ

The prospective parties to an M&A transaction often have different views regarding the value of the target company, which can make it difficult to agree upon a purchase price. The seller may be optimistic with regard to the future prospects of the business, and therefore ascribe a higher value to the business than the buyer, which may be more conservative. One common way parties bridge this valuation gap is through the use of an earnout. An earnout is a form of contingent consideration that is payable to the seller based on the performance of the target business for a period of time after the transaction closes.

Such a provision entitles the seller to receive additional payments if the business meets certain contractual milestones post-closing. Even though earnout provisions must be tailored to each specific transaction, key considerations must be addressed in the earnout structure.

  1. Performance Milestones. The parties generally agree on certain financial milestones, operational milestones or a combination of both. The typical financial milestones include thresholds based on revenue, net income or EBITDA. In some transactions, especially the sale of an early stage company, it may not make sense to use financial milestones because of the lack of the lack of historical financial data and difficulty in projecting future growth. Thus, the parties may turn to operational milestones such as a new product launch, regulatory approval or an increase in customers. Regardless of which milestones are utilized, they must be objective, clearly defined in the agreement and relatively simple to measure.
  2. Earnout Period. Careful consideration needs to be given to the length of the post-closing earnout period. Generally, an earnout period will range from one year to five years. For a short-term earnout (one year or less), there is usually only one payment due to the seller at the end of the earnout period. In multi-year earnouts, the seller will be paid in intervals, typically annually. As is likely obvious, the multi-year earnout comes with additional issues that the parties need to address at closing. These include whether the seller can meet the milestones each payout interval, whether the payout is proportional to performance or is it an all-or-nothing provision, whether the buyer’s lender (if any) imposes restrictions on making earnout payments and what happens to the earnout payments if either the buyer or the seller is sold during the earnout period.
  3. Operation of the Seller’s Business during the Earnout Period. Because the seller’s ability to receive the earnout payment depends on the future performance of the target company, the ability to control the operation of the target company during the earnout period is critical in achieving the earnout. In structuring the earnout provision, the seller should seek to include certain post-closing covenants that will require the buyer to facilitate the business reaching the earnout milestones. These covenants include: requiring the buyer to use its best efforts to reach the milestones, requiring the buyer to operate the business consistent with how the seller had operated pre-closing or in accordance with an agreed upon business plan, or restricting the buyer from engaging in any change of control transactions without the prior consent of the seller.

When properly structured, an earnout provision can bridge the gap between differing financial predictions between the buyer and seller. The earnout offers each party the ability to mitigate certain risks and, thus, allow the transaction to close.

If you would like some guidance on how to structure an earnout, please contact any of the attorneys at RMZ.

The information in this article is for informational purposes only and does not constitute formal, legal advice.  Consult with one of the attorneys from Roberts McGivney Zagotta LLC for advice about your particular circumstance.