Basic Definition
An earnout is a risk‐allocation mechanism used in an M&A transaction whereby a portion of the purchase price is deferred and is calculated based on the performance of the acquired business over a specified time-period following the closing.
Reasons for Use of Earnouts
Valuation Gap: Earnouts can bridge the business valuation gap between an optimistic seller and a skeptical buyer. Allows asset to prove its worth.
Financing: Use of an earnout in structuring an acquisition provides buyer with an additional option to finance the acquisition (i.e., buyer may be able to pay for the acquisition with future profits of the target business).
Incentive‐Based Compensation: Earnouts can also be used as a form of incentive‐based compensation to sellers who are continuing as employees of the acquired company.
Startups: Earnouts are often used for companies with little operating history but significant growth potential (which are not easily valued).
Key Structure Considerations
Principal considerations when negotiating and drafting an earnout:
- the definition and scope of the target business;
- the selection of the performance metric;
- the selection of appropriate accounting measurement standards;
- the determination of the payout structure and establishment of the earnout period;
- post‐closing operation (i.e., the allocation of control between buyer and seller and the level of support, if any, that buyer will commit to assist the target business in achieving its earnout objectives); and
- disputes and resolution.
Defining the Target Business
The scope of the target business should be clearly defined since it is the performance of this business that will determine whether earnout requirements are satisfied.
Relatively easy when acquired business will be operated as an independent subsidiary or division, but more difficult when the target is to be integrated into buyer’s existing business. In such situations, the performance of the business may be more difficult to track and special accounting allocations may be required.
Segregated financials to measure performance of the acquired business should be established.
Particular matters to be addressed include: (i) the defined line of business, (ii) whether expansion of the business beyond the defined line will count toward the earnout and (iii) sales to common customers.
