Earnouts
What is it?
An earnout is a mechanism commonly seen in mergers and acquisitions that provides for a contingent payment based on the post-completion performance of the business. It is commonly used to bridge a valuation gap between vendor and purchaser.
Structure
An earnout can be structured in many different ways and is subject to negotiation. It can be based on revenue, net profit, KPIs or other metrics related to future economic performance of the business. It can involve one or multiple contingent payments.
A commonly used structure is a sliding scale, where the earnout amount is adjusted in accordance with the performance of the business in a particular period.
Things to consider
Before agreeing on the earnout conditions there are important considerations from both perspectives.
As the vendor, it is usually best to consider an earnout as a bonus, as the earnout depends on the performance of the business, which is controlled by the purchaser and there are many factors that the vendor cannot control. For example, key clients or customers may reduce their custom with the business. Or, key employees, who are vital to reaching the earnout conditions, may cease to stay on or their performance may drop due to the change of ownership.
The vendor should think about the level of risk it is prepared to accept and, usually, seek a relatively short earnout period. Most importantly, a vendor should consider what security and/or guarantee (if any) it can seek from the purchaser or a third party in relation to the contingent payment, and how easily it can recover any earnout payment from such security.
As the purchaser, an earnout usually carries less risk than for the vendor. If an earnout is triggered, then that usually means that the business has performed well, which is for the benefit of the purchaser.
An issue to consider for the purchaser is what happens if key employees agreed to continue working in the business for the duration of the earnout period and wish to move on after that period. Whilst the earnout period may have been a success, a significant transition may lie ahead just after it. Of course, a purchaser should also plan ahead for any earnout payment (if it is triggered) and make provision for it.
Protection
A well drafted share sale or sale of business agreement should clearly state the earnout conditions, and the process for determining whether or not such conditions have been satisfied. This is essential to avoid potential dispute between the vendor and purchaser.
As the vendor, you would want access to the business’ books, records and accounts (depending on the structure of the earnout) and ensure that there is a fair and transparent mechanism for review of the earnout calculations or metrics. It is also common for the purchaser to give an undertaking that it will operate the business in accordance with certain parameters and subject to certain limitations (e.g. the purchaser will not incur related party expenses, where the earnout is based on profit).
We recommend that a vendor seek security and/or a guarantee as noted above. Also, a vendor can seek a provision, where certain expenses of the business are fixed for the purposes of calculating the earnout (this does not prevent the purchaser from actually incurring such expenses, it simply means that they are ignored for the purposes of the earn out). Finally, a vendor would want certainty that the earnout cannot be ‘reversed’, resulting in the vendor having to pay the purchaser.
As the purchaser, the earnout should be able to be set off against any liability arising from the vendor breaching the share sale or sale of business agreement. The purchaser could also request a “reverse earnout” whereby the vendor agrees to repay amounts to the purchaser, if the earnout conditions are not met.
Taxation
The tax treatment of earnout payments can be complicated. Both vendor and purchaser should seek advice about the tax implications before agreeing to any earnout.
NDL’s M&A team is happy to discuss any earnout issues or queries you may have.
