Use a Carefully Crafted Earnout to Get the Deal Done

Abstracted from: Seller, Beware: In An Earnout, The Buyer Has Doubts; The Seller Has Hopes

By: Mark Gundersen McCarter & English, Wilmington, DE

Business Law Today - Vol. 14, No. 4, Pgs. 49-53

Overview:

Describes issues that may arise when enforcing earnout provisions in purchase agreements. Recommends drafting important provisions clearly and carefully to avoid problems at the time of payout a few years after the closing.

Earnout based on future performance.

When buyers and sellers cannot agree on a price, one solution is to negotiate an earnout provision in the purchase agreement. The buyer agrees to make an additional payment to the seller in the future if the seller’s forecast for the company’s performance is realized. The earnout is generally between 10% and 25% of the purchase price with a term between one and three years. Earnouts for more than 25% of the purchase price or longer than three years begin to take on the characteristics of debt or preferred equity, attorney Mark Gundersen cautions. In that scenario, the seller will benefit from having the protections due to a debt or equity holder. The purchase agreement should make clear that the earnout provision does not constitute a representation or warranty about the company’s future performance. If the earnout numbers are not achieved, the buyer’s only remedy is to withhold payment of the earnout amount.

When the earnout is a significant part of the sale price, the seller may want to negotiate the right to continued involvement in managing the business, to avoid any question of whether the buyer has intentionally stifled earnings. Much of the seller’s protection will come from the definition of earnings. Buyer and seller must decide whether earnings will be calculated before interest and taxes or before interest, taxes, depreciation, and amortization. Buyers may seek to reduce earnings as much as possible through expenses, reserves, and adjustments. The seller should try to exclude depreciation on items purchased after the closing and the amortization of goodwill and expenses arising out of the transaction, advises the author. The purchase agreement should also specify the treatment of changes in insurance, employee terminations, and the appropriate allocations of overhead. The seller generally will want the earnout to apply only to the particular product line being sold, which could be problematic if the buyer wants to incorporate the product line into an existing business and combine the overhead expenses.

Payout considerations.

The buyer will want to set off any claims it has against the seller using the earnout provision. Sellers should allow a setoff only if it is calculated by a qualified independent third party. The parties must agree upon when the earnout should be paid. Buyers will want to make the payment only if the target earnings amount is reached; sellers will prefer a sliding scale, giving a partial payment if a portion of the target is attained. The agreement should provide that the earnings target is calculated in accordance with GAAP applied on a basis consistent with the seller’s past practice. The author notes issues that may arise concerning the appropriate level of reserves for bad debts and contingent liabilities. The seller should require an independent review of the earnout calculation, particularly if the buyer is using different accounting practices. When there is a dispute over the earnout amount, the seller ought to seek a partial payment of the undisputed amount.

Abstracted from Business Law Today

Published by American Bar Association

Section of Business Law

321 N. Clark Street, Chicago, IL 60610

Return to Library of Business Information