Earnouts are a common element used in structuring M&A deals. They are a contractual agreement in the sale of a company where the buyer agrees to pay the seller additional consideration based on future events or performance post-close. It serves to mitigate the selling company’s performance risk for the buyer and incentivize – offer a carrot to – the seller to ensure the success of the acquisition and participate in future positive outcomes of the selling company. The attractiveness of earnouts lies in the potential for substantial payouts beyond the initial transaction. Structuring an earnout involves determining metrics, duration, measurement methods, and dispute resolution mechanisms.
Earnouts are commonly used to bridge valuation gaps between buyers and sellers, especially when certain assets or operations haven’t yet demonstrated their value to the buyer’s satisfaction, or when there is significant risk to the future expected performance of the selling business. They can be based on various metrics such as revenue, gross profit, customer retention, or profitability level. However, disagreements often arise regarding the measurement criteria and post-closing control, as sellers seek assurances of the target’s performance, while buyers aim for operational discretion. Establishing precise terms and procedures for earnout calculations is crucial to minimizing disputes.
Buyers may prefer earnouts based on net profits, while sellers often prefer metrics “further up the P&L,” such as revenue or gross profit, to reduce manipulation risks (whether intentional or inadvertent). Earnouts typically extend for one to three years from closing, and in some cases, they may encompass non-financial measures like contract renewals or employee retention. Finding a middle ground regarding post-closing control through operational covenants can help alleviate tensions between buyers and sellers, ensuring a smoother transition and realization of earnout potential.
