A Look In on EarnOuts

"Earn-outs are most often used when the buyer and sellers cannot agree on the value of the target." So begins Structuring and Negotiating Earnouts from PLI by Maryann A. Waryjas (Katten Muchin Rosenman LLP). Fraught with issues and pitfalls, this deal device "makes a portion of the payment to the sellers contingent upon the target reaching specified milestones during a specified period after the closing." The milestones used are usually financial, such as net revenues, gross profits, EBIT, EBITDA, net income or earnings per share.

Some of the risks associated with the use of earnout provisions include:

"a. Earnouts have great potential for engendering later dispute about the contingent payment. Disputes often arise when the sellers suspect that the buyer is using different accounting techniques during the earnout period to diminish the payout, or is artificially depressing revenues or earnings during the earnout period.

b. The sellers may fear that the buyer will not run the business successfully.

c. Buyer faces the risk that the payout formula will overcompensate the sellers due to other acquisitions or a change in the buyer's post-acquisition business plan that has little to do with the target.

d. Earnouts tend to limit the ability of a buyer to integrate the target's business into the buyer's other business.

e. Buyers can use earnouts as a source from which they can offset indemnification claims."

Operational issues abound in the determination of whether milestones have been reached, such as:

(a) Operation by the buyer post-closing. Usually the buyer will control and manage the business of the target after closing. In situations in which the target's management team will not be retained post-closing, the sellers will likely require that the buyer operate the target in the ordinary course of business consistent with past practice, and will attempt to reserve, through contractual covenants, some authority regarding major decisions made during the earnout period.

(b) Operation by the sellers' management team post-closing. Sometimes the target's management will continue to manage the business post-closing. In this situation, the buyer risks that the target's management team will operate the business so as to inflate the payout.

(c) Protections placed in the agreement. The parties may also wish to detail operational specifics in the acquisition agreement in order to avoid uncertainty. For example, the buyer might agree to restrictive covenants that prevent the target from taking specified actions during the earnout period. The seller may require that the buyer adequately fund the target during the earnout so it will be able to capitalize on opportunities presented to it."