Navigating the complexities of business transactions often involves exploring innovative solutions to bridge valuation disparities between buyers and sellers. In the realm of purchase prices, the concept of earnouts emerges as a strategic tool, offering both parties a pathway to align their interests while addressing uncertainties surrounding future performance.
Let’s delve into the dynamics of purchase price negotiation, earnout structures, and the intricate considerations that shape these agreements.
Purchase Price
If you are selling your business for $32,000,000 and $5,000,000 of the $32,000,000 will be paid through an earnout, my response to you is that you are selling your business for $27,000,000 with the opportunity to have sold it for $32,000,000. An earnout is additional consideration which is paid by the buyer for the seller’s business upon the achievement by that business of certain financial thresholds or milestones following the closing of the sale. For instance, achieving a minimum EBITDA[1] for the twelve-month period following the sale or being awarded a particular contract. There is no certainty that the earnout will be achieved. Accordingly, the earnout is a contingent payment.[2]
Bridging the Gap
An earnout is commonly used to bridge differences in the valuation of a business between the buyer and the seller. Sales are often priced based on a multiple of historical EBITDA of the business. This approach may not work well for a business that has an expectation of a material increase in its EBITDA. Assume a business has consistently achieved EBITDA of $8,000,000 and the buyer is paying a multiple of 8 times that EBITDA (i.e., a purchase price of $64,000,000). Further assume this business booked a lucrative contract with a new customer which is projected to increase the EBITDA of the business by $1,000,000 in the following year. Theoretically, if the seller waited a year to sell the business and achieved the additional $1,000,000 of EBTIDA, the seller might receive an additional $8,000,000 for the business. However, the buyer and seller desire to close the transaction now. To bridge the uncertainty of whether the additional $1,000,000 in EBITDA will be achieved, the sale could provide for an initial purchase price of $64,000,000 with an earnout payment of up to $8,000,000 in the event the business achieves EBITDA of $9,000,000 in the year following the closing of the sale.
Common Approaches
Cliff versus sliding scale
Buyers prefer an all or nothing or so-called “cliff” approach to the earnout payment. For example, if the EBITDA threshold is $1,000,000 and the actual EBITDA achieved is $900,000, the seller receives no earnout payment. Sellers of course prefer a sliding scale approach where a seller receives a percentage of the earnout payment based on the percentage of the threshold achieved. In the preceding example, the seller would receive 90% of the earnout payment because the business achieved 90% of the EBITDA threshold of $1,000,000. Buyers will resist a sliding scale approach. If a buyer does agree to this approach, typically there is no earnout payment if the business fails to achieve at least 80-90% of the threshold. In addition, the percentage of the earnout payment is typically less than the percentage of the threshold achieved. For example, the earnout payment for achieving 90% of the threshold might be 70% of the maximum earnout payment.
Multiple payments
An earnout can provide for multiple payments based on obtaining thresholds for multiple periods. However, earnouts rarely extend beyond three calendar years from the date of sale. If the earnout is structured with multiple payments over multiple periods, the seller will often request the right to apply any excess over the threshold in one period to another period for which seller did not achieve the threshold. For example, assume a threshold of $1,000,000 of EBITDA in each of first two years following the closing and an earnout payment of $250,000 for each year the business achieves that threshold. In year one, seller achieves EBITDA of $800,000 and in year two achieves EBITDA of $1,300,000. In the absence of the ability to apply the excess over $1,000,000 in year two to the shortfall in year one, seller’s earnout would be a payment of $250,000 for achieving the threshold in year two. If seller can make that application then the seller’s earnout would consist of a payment of $250,000 for achieving the threshold in year two and a payment of $250,000 for achieving the threshold in year one after giving effect to the application.
Commencement period
If it is anticipated that there will be a period of integration post-closing that may adversely affect the financial performance of the business during that period, the Seller may request that the measurement period for the earnout commence on a date later than the date of the closing of the sale. If so requested, the period will often commence 45-90 days from the date of the closing of the sale or perhaps with the first day of the next fiscal year of the business.
Top Line-Bottom Line
For a middle market closely held business, sellers typically prefer an earnout based on revenue since revenue is easier to calculate and avoids issues with respect to actions that the buyer may take post-closing which adversely affect the net profitability of the business. The buyer typically prefers a threshold that is based on EBITDA or other computation that includes the operating costs and expenses associated with the business. If the threshold is based on the business’s net operational performance, the seller will insist that the costs and expenses be consistent as to category, type and possibly amount, as those which were incurred pre-closing. Typical carve outs to costs and expenses include the transaction fees and expenses incurred by the business in consummating the sale and any fees and expenses paid to buyer’s sponsor.
Whose Business is this?
There is an inherent tension in an earnout. The buyer has paid a substantial sum for the business, and may desire to operate the business, or at least have the flexibility to operate the business, in a manner that impairs the short-term profitability of the business but maximizes its long-term prospects. Seller desires that the buyer not take any action which can impair seller’s achievement of the earnout. The seller may propose restraints on the buyer during this period, but buyers will typically resist any such restraints. Standards of conduct for the buyer post-closing, such as “operate the business in a manner which could not reasonably be expected to impair achievement of the earnout” or similar standards of conduct are helpful to seller but are imprecise, and, accordingly, present litigation risk.
Mechanics
The purchase agreement governing the sale of the business customarily provides that the buyer and its accountants will prepare the calculation to determine whether the seller has achieved the threshold for the earnout. Upon receipt of that calculation, the seller and its accountants are given an opportunity to review the calculation and the supporting documentation. In the event the seller objects to the calculation, a third independent accountant is typically identified in the purchase agreement to final determine the items in dispute.
Acceleration
It is not uncommon for seller to negotiate that in the event of a subsequent sale of the business by the buyer prior to the end of the earnout period, the earnout is deemed fully earned and payable upon the consummation of the subsequent sale. In addition, in the event the seller is an individual who will be employed by the buyer to continue to run the business post-closing, the seller may request that the earnout be deemed earned in full and payable in the event the seller’s employment is terminated without cause. The rationale for this request is that the seller views his or her continued employment with the business as critical for the business to achieve the earnout.
Risk Assessment
Ultimately, the earnout is an allocation of risk that is borne by the seller. The seller should take into account three particular items when evaluating this risk.
How meaningful is the achievement of the earnout?
Some sellers may view the upfront purchase price for its business as sufficient value for the business and view the earnout as “icing on the cake.” Other sellers may view the achievement of the earnout as critical to their achieving fair value for their businesses. These sellers view the earnout as deferred purchase price (i.e., the earnout should be obtainable so they are only deferring the timing of payment), and, accordingly, there may be greater litigation risk to the buyer if the earnout is not achieved.
How difficult will it be to determine if the earnout threshold has been met?
EBIDTA is relatively easy to determine when the buyer intends to operate the acquired business on a stand-alone basis post-closing. It becomes more difficult to determine EBITDA if the buyer intends to fold the business into its existing business or if the buyer currently operates a competing business. In this instance, in defining EBITDA, one must account for, among other items, allocations of overhead to the acquired business, allocations of revenue from new customers (i.e., should the revenue be credited to the acquired business or the buyer’s existing business) and intra company sales which may occur at cost (seller desires that these sales be accounted for at the current market price payable by third parties).
Is the buyer a good bet?
The financial stability of the buyer, the skill of its management team, and its articulated vision of the business post-closing should be significant considerations for the seller. Obviously, a highly leveraged buyer presents greater risk to the seller of not receiving its earnout than a well-capitalized buyer. A highly competent management team coupled with a shared vision for the future of the business may provide seller some assurance that the business in the hands of the buyer can reasonably achieve the threshold.
A Bird in the Hand
Due to concerns as to whether the business will achieve the earnout (i.e., business risk), and whether the parties adequately defined the parameters of the earnout and its computation in the purchase agreement (i.e., documentation risk), some buyers and sellers may agree to forego an earnout and increase the purchase price payable at closing by an amount discounted from the intended earnout amount. In addition to the obvious “bird in the hand” benefit of this approach, there is an added benefit for sellers who are employed by the buyer post-closing. Even if there are legitimate differences between buyer and seller as to whether the earnout was achieved, the buyer and the seller may be dissuaded from disputing the earnout so as not to adversely affect their ongoing relationship.[3]
The Rule is there are no Rules.
Whether to accept an earnout is ultimately a business decision. Legal counsel and accountants can assist in mitigating the risk attendant to the earnout but there is always risk. Neither the seller nor the buyer should feel constrained by what is “customary and usual” in structuring the earnout-it should be negotiated based on the specifics facts and circumstances of the sale transaction.
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[1] Earnings before interest expense, taxes, depreciation and amortization. EBITDA excludes non-operating items and, accordingly, provides insight as to the operating profitability of a business.
[2] Contrast this payment with a deferred payment which is not subject to any contingency. A deferred payment is simply paid on a date following the closing date. It can be a sum certain or a formula which is not subject to a threshold. An example would include a payment following the closing date equal to 50% of all receivables that were 180 days past due at closing and which are collected within 6 months of the closing.
[3] Such a seller could be an individual whose business is acquired by a private equity sponsored company as its initial acquisition in a particular industry- a so called platform company. The seller typically will receive cash and roll over some equity into the platform company. That platform company will then seek to acquire or “roll up” other companies in the same industry. If the seller is brought on as a senior member of the management team for the platform company, the economics attendant to that position and the potential gain from the roll up shares may exceed the earnout by a multiple. Seller’s desire to preserve those economics and buyer’s desire to keep a key member of the management team enthusiastic and motivated, may result in an approach to an earnout dispute that is different than the approach which would be taken in the absence of these desires.