If you’re thinking about selling your business, your earnout deserves special attention.
In an earnout, the buyer may offer the seller a higher number but with strings attached. The valuation is based on future projections, which may or may not be realized. The seller can earn more than he or she initially wanted, but also has the risk of earning less based on criteria to be negotiated.
The earnout can be beneficial because the seller receives some of the purchase amount over time. This means the buyer needs less cash to close and may not need third-party financing. It also provides the buyer a potential offset for indemnification claims.
Some of the risks include the seller losing control of the business, making it difficult to hit the earnout targets. If the seller stays on in a management role, he or she is self-interested and may not be on the same page as the buyer. In turn, the buyer may need to delay integration during the earnout period.
There are some questions to consider about the earnout itself. First, what is the earnout amount? Typically, it is 10 to 25 percent of the total sale price. The buyer generally prefers a higher percentage, while the seller generally prefers a lower percentage. Is the amount a fixed dollar amount or a percentage? Based on what? Is there an aggregate cap? How about a shortfall ramp-up?
Next, what’s the earnout’s duration? Typically, it’s one to five years. The buyer generally prefers a longer period, while the seller generally prefers a shorter period. The buyer typically gains more control over time, making it more difficult for the seller to control the earnout results. Longer time periods may be better structured with the seller as a creditor or preferred shareholder.
Next, what are the criteria? Typically, a buyer prefers metrics closer to net profit, while a seller prefers metrics closer to revenue. Middle-ground metrics are earnings before interest and taxes (EBIT) or earnings before interest, taxes and amortization (EBITDA).
Nonfinancial metrics may include a new product or service launch, customer retention or whatever is most meaningful to achieve during the earnout period. Keep it simple. The more complex, the more potential for disagreement and litigation.
Let’s look at some other considerations. Negotiating the fine details of an earnout is one of the most overlooked areas of the transaction.
Accounting integration affects the ability to calculate the earnout amount. Buyers are often interested in integrating accounting systems during the earnout period. Sellers prefer to maintain the status quo so their earnout performance may be properly calculated. Third-party audits to verify earnout results are a good solution.
Transaction-related expenses include fees for attorneys, accountants, consultants and more. The accounting treatment affects financial results, so don’t overlook this area. Buyers prefer to include these expenses in current income calculations because they reduce net profit and the earnout if tied to net profit. Sellers prefer to exclude these expenses from earnout calculations.
There may be extraordinary expenses, such as nonordinary gains or losses, insurance proceeds, tax implications, force majeure events, etc., that arise during the earnout period. If so, their accounting treatment may impact financial results and the seller’s earnout.
Depreciation treatment greatly affects financial results. Buyers prefer step-up in basis to gain more depreciation expense. Sellers prefer to maintain historical depreciation treatment. Again, there is a potential for conflict if not negotiated up front.
The accounting treatment of overhead impacts financial results. Buyers prefer overhead to be recalculated as part of their integration, while sellers prefer to maintain the status quo during the earnout period.
The integration of business operations may affect the seller’s ability to achieve and calculate earn-out performance, but delays in integration affect the buyer’s ability to benefit from integration. Buyers prefer faster integration while sellers prefer slower or no integration.
Legal considerations — disclaimers, representations, warranties and remedies — are vital. Consider using third parties to calculate earnouts and set-offs and working with a qualified escrow agent to hold funds until disagreements are resolved.
All details are negotiable but are often overlooked in the rush to get the deal done. Earnouts that are not well-designed and negotiated often result in litigation. By taking a few extra steps before closing, there is a better chance for a smooth transition.
Now go forth.
