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Strategic Considerations of Earnout Provisions

With the recent uptick in M&A activity, there seems to be renewed interest in earnout provisions. In some cases, buyers and sellers of businesses cannot agree on the value of the assets under consideration. For example, with newer businesses or those with developing technology, the historic level of earnings of the business may not reflect its expected value or future potential. The seller may not be willing to agree to a transaction based on historical earnings that do not reflect expected growth, and the buyer may not be willing to pay more based on that earnings potential.

One way to bridge the gap, when buyers and sellers bring different perspectives on value, is through the use of an earnout provision. An earnout allows the parties to agree that a certain portion of the purchase price will be contingent on the future performance of the company over a set period of time. This performance is usually tied to achieving a particular benchmark or hurdle.

Potential benefits of using an earnout to both the buyer and seller include:

• Bridge the gap in purchase price;
• Create incentives for the sellers to achieve certain results, if they are going to remain and be involved in the management of the company;
• Provide another method of financing to the sellers;
• Protect the buyer from potential overpayment for a business; and
• Potentially defer a portion of the seller's taxes on the transaction.
• However, determining the terms of the earnout provisions can be challenging.

There are many risks and pitfalls both buyers and sellers should consider:

Basis of the Performance Metric

Various performance metrics can be used when crafting an earnout. Parties may use a metric based on Generally Accepted Accounting Principles (GAAP), such as net revenue or net income. In most cases though, parties use other financial metrics, including earnings before interest and taxes (EBIT) or earnings before interest, taxes, depreciation and amortization (EBITDA). Parties can also draw upon other measures of cash flow, earnings per share or tie the payment of the earnout to certain performance outcomes, such as the number of new contracts or the achievement of a particular regulatory hurdle.

Typically, sellers prefer metrics based on revenue and buyers tend to prefer metrics based on net income, so that there is an incentive to contain cost in generating new revenue. The more complicated the calculation, the more likely it is that the parties will have a dispute later about the earnout amount. The parties should choose a metric that encourages the behavior to generate the results they wish to achieve for the business.

Payout Amount and Timing of Payment

Consideration should be given to the amount of the earnout, when it should be paid and how it should be paid (in cash, stock, notes or a combination of these). If stock is to be used as the payment, it will be important to determine the date at which to value the stock, whether it be the acquisition date, the date that the earnout is earned or the payment date.

There are many ways to structure the earnout; it can be paid as one amount at the end of a period based on a cumulative metric or it can be paid based on milestones that need to be met at various junctures throughout the earnout period. It should also be considered whether a prorated payment should be made to the seller after a certain minimum milestone has been met. The seller may also wish to entertain the option of a cap on the amount of the earnout.

In regards to the period of time over which the earnout should be paid, the seller has an incentive to have its earnout paid out as soon as possible. Conversely, the buyer will want to make the earnout period last as long as possible to determine if the objectives of the earnout are met, but also has an incentive not to drag the period out longer than necessary, so that the earnout does not become a distraction to running the business.

Control of the Business

Frequently, disputes arise because the buyer controls the business after the sale, and can take actions that may seem detrimental to the seller, failing to maximize the earnout. A potential conflict can arise if the buyer feels that they should be making all the decisions in running the business, but the seller still has a financial interest in how the business is run. In order to reduce some of these issues, the seller may wish to require the buyer to maintain a certain level of funding of the business during the earnout period, maintain a minimum number of sales people, use "commercially reasonable efforts" during the earnout period to sell products or services and refrain from terminating certain key employees, whom the buyer hired at the closing, if appropriate.

Another issue for consideration is the effect of a change in control and its influence on the earnout. Should the seller be entitled to the full earnout at this point or a portion of it? The parties should reach an agreement on how major decisions that can affect the earnout (either directly or indirectly) will be made, and detail the impact of a change in the control on the business. The parties may wish to outline these areas in the earnout provision of the purchase agreement.

Measurement of the Earnout

Another potential area of dispute is measuring whether the earnout is actually earned during the period. Many disputes arise when measuring the performance of the business against the designated metric. The effect of extraordinary items or non-recurring items, allocations of corporate costs such as overhead and any items that might be subjective within financial statements may create disagreements. The nature of accounting inherently requires many judgments and estimates, which often spur disagreements when the buyer and the seller "true up" the earnout amount. Careful crafting of the terms of the earnout provision may help reduce such disputes.

Maintenance of and Access to the Books and Records

Another way to potentially reduce the likelihood of disputes regarding the measurement of the earnout is to require the buyer to maintain separate books and records for the purchased entity. The buyer typically "controls" the records after the closing date and any lack of transparency or issues concerning the integrity of the buyer can be detrimental to the seller. The seller should therefore request periodic reporting of the drivers of the earnout, with the right to inspect and / or audit the underlying books and records of the purchased entity to test its progress towards achieving the earnout and validate the buyer's calculation thereof. The need for transparency is particularly important in cross-border acquisitions with different financial reporting standards and practices that may be less rigorous than U.S. GAAP or IFRS.

Consideration of FASB ASC 805 and IFRS 3R

Parties should also consider Statement of Financial Accounting Standards No. 141R ("FAS 141R") when entering into earnout provisions. FAS 141R was issued in December 2007, and went into effect for business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. Its counterpart in International Financial Reporting Standards is IFRS 3R. FAS 141R has been codified under FASB Accounting Standards Codification as FASB ASC 805 as of July 1, 2009. Under ASC 805 and IFRS 3R, the buyer must recognize the fair value of the earnout as of the acquisition date as either a liability or equity. Earnouts recognized as a liability must be remeasured to fair value regularly and the change to the fair value must be recognized in the income statement of the purchased entity. Historically, earnouts were recognized when they were resolved, not at the time of acquisition. Measuring the fair value of an earnout provision can be complex, so buyers should understand these provisions to determine how their provisions will affect the company’s financial reporting.

Resolution of Disputes

Finally, the parties may wish to consider the method of resolving disputes related to the earnout, as such disputes are fairly common. The most common way to resolve these matters is through an arbitration or expert determination process before an independent accountant.

Conclusion

Although earnout provisions can create issues in the form of disputes between buyers and sellers, they deliver many benefits. The key to a successful closing is for both parties to understand the provisions of the earnout and to ensure that the mutual understanding is well documented.