Structuring Earnout Agreements in Business Acquisitions: Opportunities and Challenges
When businesses engage in acquisition transactions, structuring the deal in a way that balances risk and reward for both the buyer and the seller can be complex. One tool often used to bridge the gap between buyer and seller valuations is an earnout agreement. Earnouts allow sellers to receive additional compensation after the sale, contingent on the post-sale performance of the business. These agreements can help resolve valuation disagreements but also pose risks for both parties, especially if they are not clearly structured.
This article will explore how earnout agreements work, the benefits and challenges they present, and how both buyers and sellers can navigate their complexities.
What is an Earnout Agreement?
An earnout is a contractual provision in an acquisition agreement that allows the seller to receive additional payments after the sale based on the future performance of the acquired business. The buyer agrees to pay a portion of the purchase price upfront, with the remaining amount contingent upon meeting specific financial or operational milestones during a defined period after the sale.
Earnouts are typically tied to measurable benchmarks such as:
These benchmarks provide a framework for determining whether the seller should receive additional compensation beyond the upfront payment.
Benefits of Earnout Agreements
Earnout agreements can be advantageous for both buyers and sellers by mitigating certain risks and facilitating the closing of an acquisition.
1. Bridge the Valuation Gap
One of the key reasons for using an earnout arrangement is to resolve differences in how the buyer and seller value the business. Often, the seller may believe that the business has high future growth potential, while the buyer may be more skeptical about the prospects. In this case, an earnout allows the seller to receive compensation for future growth if the business achieves key milestones, without the buyer having to overpay upfront based on speculative growth.
For example, if the seller believes the business will generate $10 million in revenue in the next two years, but the buyer is uncertain, an earnout can stipulate that the seller will receive an additional payment if this target is met. This structure ensures the buyer only pays for performance, while the seller has the opportunity to maximize their compensation if projections are accurate.
2. Incentivize Seller Involvement Post-Sale
In situations where the seller continues to manage or be involved in the business after the sale, an earnout can serve as an incentive for the seller to stay committed to the business's success. By tying compensation to performance, the seller has a financial stake in ensuring the business grows and meets its targets, creating an alignment of interests between buyer and seller.
3. Financing the Acquisition
From the buyer's perspective, an earnout arrangement can serve as a form of acquisition financing. Instead of providing the full purchase price upfront, the buyer only pays a portion, deferring the remaining payment until the business meets specific performance targets. This approach helps buyers manage their cash flow and reduces the risk of overpaying for a business that underperforms.
Additionally, earnout payments may be structured to allow buyers to offset claims against the seller. For example, if the seller provides indemnities in the acquisition agreement, the buyer could reduce the earnout payments if it needs to make indemnification claims.
Challenges of Earnout Agreements
Despite their benefits, earnout agreements also present a range of challenges for both buyers and sellers. These challenges often revolve around disputes over performance measurements, management control, and the potential for post-sale conflicts.
1. Performance Metrics and Manipulation
The structure of earnout agreements relies on clearly defined performance benchmarks. However, determining the right metrics can be tricky, and how they are measured can lead to disputes. For example, sellers may prefer revenue-based metrics, which are not impacted by the buyer's management decisions on operating costs. On the other hand, buyers may prefer profit-based metrics (such as EBITDA), which take into account the business's operating expenses.
Disputes can arise if either party believes the other is manipulating the business’s performance to influence the earnout calculation. For instance, a seller may cut necessary spending on research and development or marketing to artificially boost short-term revenue. Similarly, a buyer could allocate excessive administrative costs to the acquired business, reducing its profitability and thereby reducing the seller’s earnout payment.
2. Integration Issues
Earnout agreements are particularly challenging when the acquired business is fully integrated into the buyer’s existing operations. Integration may involve shared resources, costs, or overhead, making it difficult to isolate the performance of the acquired business for the purpose of calculating the earnout. When a business is integrated into a larger organization, measuring performance becomes more complex, and this can open the door to disputes over how certain costs are allocated.
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For example, if a buyer merges the acquired business into one of its existing divisions, how does it separate the revenue and expenses of the acquired business from the rest of the division? These issues need to be addressed upfront, and detailed accounting procedures should be specified in the earnout agreement.
3. Conflicting Priorities
Earnout agreements can create conflicting priorities between the buyer and the seller. The seller, motivated by the earnout, may focus on short-term performance to maximize their compensation, even if it means sacrificing long-term growth. Conversely, the buyer may make decisions that benefit the company in the long run but reduce short-term profitability, potentially reducing the seller’s earnout payment.
For example, if the buyer invests in capital improvements or acquisitions that lower short-term profits but enhance the long-term value of the business, the seller may feel unfairly deprived of their earnout. Addressing these potential conflicts in the earnout agreement is crucial to avoiding disputes.
Structuring Earnout Agreements
Given the potential for conflicts and disputes, it is essential to carefully structure earnout agreements to protect the interests of both parties. This includes setting clear benchmarks, defining accounting procedures, and establishing mechanisms to resolve disputes.
1. Choosing the Right Performance Benchmarks
Selecting appropriate performance benchmarks is critical. Common benchmarks include:
The choice of benchmarks depends on the nature of the business and the specific goals of the earnout agreement.
2. Defining Clear Accounting Principles
Disputes often arise over how performance metrics are calculated. To avoid this, the earnout agreement should specify the accounting principles that will be used to calculate the benchmarks. Generally Accepted Accounting Principles (GAAP) are a common choice, but because GAAP offers flexibility, it is important to specify consistent accounting methods between pre-closing and post-closing periods.
The agreement should also address adjustments for extraordinary items, such as acquisition-related costs, and clarify how intercompany transactions, depreciation, and amortization will be treated.
3. Establishing a Dispute Resolution Mechanism
Given the potential for disputes, it is wise to include a clear dispute resolution mechanism in the earnout agreement. This could involve arbitration, mediation, or appointing a third-party auditor to resolve any disagreements over performance calculations. Including such a mechanism reduces the risk of costly litigation and ensures that disputes can be resolved in a timely manner.
4. Managing Post-Sale Operations
In some cases, the seller may remain involved in the business as a manager after the sale. This can help ensure that the seller has the necessary control to meet the earnout targets. However, if the seller has no managerial role post-sale, the buyer may have more control over decisions that impact the earnout calculation.
The earnout agreement should specify the extent to which the buyer can make decisions that impact the business’s performance. This might include restrictions on how much administrative overhead can be allocated to the business or limits on capital expenditures during the earnout period.
Legal Considerations: Good Faith and Fair Dealing
As highlighted by the case Horizon Holdings, LLC v. Genmar Holdings, Inc., courts can interpret earnout agreements using principles of good faith and fair dealing. In this case, the buyer took several actions that, while not explicitly prohibited by the contract, undermined the seller’s ability to achieve the earnout targets. The court ruled that the buyer had violated the implied covenant of good faith by acting in a way that deprived the seller of the opportunity to earn additional compensation.
To avoid such disputes, it is critical for both parties to articulate their expectations in the earnout agreement clearly. The seller should negotiate protections to ensure that the buyer does not take actions that would unfairly prevent them from achieving the earnout. Similarly, the buyer should ensure they have flexibility in managing the business post-sale without creating conflicts over the earnout.
Conclusion
Earnout agreements are a powerful tool for balancing risk and reward in business acquisitions. By tying part of the purchase price to the future performance of the business, buyers can protect themselves from overpaying for a business that underperforms, while sellers can benefit from the business’s post-sale success. However, earnouts come with challenges, particularly when it comes to measuring performance and managing post-sale operations.
Both buyers and sellers must approach earnout agreements carefully, selecting appropriate benchmarks, defining clear accounting practices, and including provisions to resolve disputes. When structured properly, earnouts can benefit both parties and lead to successful business acquisitions.
For expert guidance on structuring earnout agreements and navigating complex business acquisitions, Business Valuation Advisors is here to help. Our team specializes in creating tailored solutions for business transactions, ensuring that both buyers and sellers achieve their goals.
Visit www.ValuationAdvisor.com to learn more or schedule a consultation today.