Structuring Earnouts to Break M&A Deadlocks

In this case, the baseline value should be $10 million, and an earnout could be structured based on the acquisition of the new customer. The earnout amount is the additional payment that buyer agreesto pay seller if specific performance metrics are met. Performancemetrics can include financial targets or business-relatedmilestones.

1. The seller is interested in getting the highest possible price, of course, while the buyer might be apprehensive about the company’s ability to grow as promised or keep customers and key employees.
2. Earnouts offer parties more flexibility in structuring deals, allowing buyers to allocate a portion of the purchase price based on the business’s future performance.
3. For example, if a minimum (usually called a floor) is $25,000, the buyer may not file an indemnification claim if the claim is less than $25,000.
4. Generally speaking, buyers want to ensure sellers have as much skin in the game as possible.
5. For example, if an earnout pays the seller 3% of revenue only if annual revenue exceeds $10 million, what should the amount be if the business generates revenue of $12 million in the first year, $20 million in the second year, and $8 million in the third year?

Technically, equity is not normally granted but instead is rolled over. In other words, the buyer may only purchase 70% of the seller’s shares, for example, and the seller retains a 30% interest. Long-term earnouts of five years or more earnout data from m&a deals should probably be replaced with equity incentives. The primary advantage of equity as an alternative to earnouts is that it does a better job of aligning incentives and can be used as a long-term strategy for 5, 10, or 20 years.

Accounting Considerations for the Buyer and the Seller

Generally speaking, buyers want to ensure sellers have as much skin in the game as possible. In most cases, several of these tools are used collectively to mitigate the risk and keep the seller on the hook. It is common for parties to negotiate whether restrictions on the post-closing operation of the business are appropriate.

What is an earnout in M&A?

And maintaining your negotiating posture sends buyers the subtle message that you aren’t susceptible to such ploys. This article will educate you about what an earnout is, how it can fit into the sale of a business, and the many factors and concerns that both buyers and sellers need to understand about earnouts. We will discuss the general purposes, advantages, and challenges of an earnout, the key elements of an earnout, the legal and tax implications involved, and how deal structures may be put together. An earnout is a useful means of bridging a valuation gap and getting a deal done.

Earnouts can also be used in lieu of escrow, and indemnification claims can be deducted from earnout payments. In the context of a mergers and acquisitions (M&A)transaction, an “earnout,” is a mechanism used tostructure the purchase price paid for a company. In manytransactions, buyer pays seller the entire purchase price atclosing. In others, buyer and seller agree to a purchase pricestructure where a portion of the purchase price will be paid atclosing, with an additional amount paid post-closing under certaincircumstances.

What is an earnout?

An earnout is a clause in a contract that provides for additional compensation to selling parties if certain performance targets are hit. Earnouts are most often used in commercial transactions like mergers or acquisitions. Second, an earnout can work as a motivational and retention mechanism for the seller’s key management team to continue operating the business successfully after the acquisition has closed. An accountant will play a key role in drafting an earnout agreement due to the potential tax and accounting implications. An investment banker can also be instrumental in providing a preliminary range of value for your company and preliminary transaction structuring. This could include estimating the possibility and degree of an earnout that may be included in offers from buyers.

Earnouts: Structures for Breaking Negotiation Deadlocks

The earnout period is the timeframe during which performancemetrics must be achieved. For longer earnout periods, the parties usuallyagree to specific dates on which performance is measured todetermine whether performance metrics have been met. Earnoutpayments can be structured in various ways, including lump sumpayments, installment payments, and payment of a percentage offuture profits. Of course, if performance metrics are not met bythe expiration of the earnout period, no earnout payment isdue. For this reason, core checks and balances such as the seller’s right to access the financial reports of the company – at varying intervals and with varying levels of detail – are put in place to offset some of these concerns. Negotiations of earnout provisions can be time consuming and costly and by the same token, litigation is not unusual.