Sell Side M&A Blog Series - Vol 3 - Earn-Outs ... Do They Work?

An earnout provision in a business sale refers to a transactional tool used to compensate a seller for future profits or sales.  It is a contingent provision of the purchase price and is typically an amount paid in addition to the base purchase price.

An earnout provides for additional compensation to the seller if the financial performance of the company exceeds certain pre-determined levels. An earnout provision can provide real advantages to both the buyer and seller.  Some circumstances are particularly conducive to a transaction structure with an earnout component.  An acquirer customarily wants to buy based on today’s earnings or sales and conversely the seller seeks a price based on tomorrow’s profits or sales due to the “potential” of the business.  Situations in which an earnout may apply include:  If the price gap between buyer and seller valuation is significant, an earnout can be a reasonable method to bridge this difference based upon actual future results.  For example, a seller may believe the company is poised for substantial expansion and therefore deserves an aggressive or premium price.  An earnout rewards the seller financially should the expansion materialize but will not penalize the buyer if the expansion does not take place.  If the business is heavily dependent on the seller’s relationships, an earnout can incentivize the seller to properly transition these relationships after the closing.  It also creates an additional incentive for the seller to remain with the company in a productive capacity post closing.  If the company is introducing new products or services that are not reflected in historical performance and have yet to materialize into tangible sales and earnings, an earnout provides the seller with an opportunity to reap the rewards on the investment made prior to the closing.  This is also applicable to situations in which the firm may be losing money, but is turning the corner toward profitability.  The company may have major customer concentrations or may be on the verge of receiving a very large contract or order. An earnout enables the seller to be compensated for these events without adversely affecting the buyer should they not materialize.

Many professionals think that earnouts should only be used if absolutely necessary to complete the transaction. Possible reasons why earnouts may not be appropriate include:  The seller does not intend to remain with the company for the earnout period.  In that case, a seller may not be interested in an earnout if they have no control over the company’s performance.

• In the event the buyer and seller do not have a comfort level with one another, it would be difficult to implement a mutually acceptable earnout. 
• Earnouts can be difficult to administer and may complicate a transaction that would otherwise be straightforward and well defined. 
• It may be difficult to determine the future variable to which the earnout will be linked (i.e. sales, gross profit, net profit, etc.) 

Deciding what to use as a benchmark is one of the preliminary points to determine in structuring an earnout.  Should the benchmark be linked directly to gross sales, gross profit or pre-tax net profit?  It is risky for a seller to allow net profit to serve as the benchmark since the buyer can control net profitability by increasing selling, general & administrative expenses, thus lowering net earnings.  The downside for the acquirer in allowing the earnout to hinge on sales is that the seller may be incentivized for unprofitable sales.  A compromise solution is to link the earnout to a specifically defined formula to determine gross profit.  For example, in a distribution business it may be gross sales less cost of product and freight in. In a manufacturing or service business, it may be gross sales less material costs and direct labor costs. This rewards profitable sales and removes discretionary operating expenses from the equation.  An earnout is usually based upon an incremental amount above a base performance level. The base purchase price is already accounted for in the guaranteed portion of the purchase price (cash and promissory note). The earnout component therefore will apply to incremental amounts. It can also be structured to work on a cumulative basis so shortfalls in one period can be made up for by a strong future period. Non-operating income and any sale of non-producing assets are normally excluded. An earnout period typically ranges from one year to five years.

In today’s economy, where rapid changes are commonplace, technology is fast-paced and there is a high degree of uncertainty, an earnout provision may be an appropriate solution to make the deal work. It can be structured as a “win-win” since the buyer is happy to pay the additional purchase price if there is additional revenue with which to pay it. The seller benefits by only sharing in the profit, while the acquirer assumes all of the risk.  However, an earnout will only work well if it is carefully structured and fairly benefits both sides of the deal.