Purchasing or selling a company is a difficult process, with the acquired business value at stake. For a transaction to be successful in mergers and acquisitions (M&A), the parties should take commercially reasonable efforts to bridge value gaps. In the realm of M&A modeling, earnouts present a complex mechanism designed to align interests and assist agreements that may otherwise fail.
Earnouts in U.S. deals typically pay out 21% of their maximum potential value. For deals where any earnout is achieved, approximately half of the maximum earnout amount is paid. When it comes to understanding earnouts, it is not only about the financial mechanics; rather, it is about forming a strategic vision for careful execution.
What is an earnout?
An earnout is a contractual clause included in a merger and acquisition agreement. It enables the seller to obtain extra remuneration provided that the target company operates as anticipated after the sale. Earnouts enable buyers to mitigate risk and guarantee that incentives are aligned.
When part of the acquisition price is contingent on the acquired firm meeting future financial or operational objectives over a defined period, this is referred to as an earnout.
How does an earnout work?
To better understand and define mergers and acquisitions, earnouts work by delaying the payment of a part of the total purchase price and making the payment contingent on the target company’s post-acquisition performance.
An example of this is a buyer agreeing to pay an initial amount upfront, with further contingent payments upon the target company hitting net sales, financial milestones, EBITDA objectives, or customer retention goals over one to three years.
| Feature | Earnout payment | Upfront payment |
|---|---|---|
| Definition | The business’s future performance affects the buying price. | After the contract is signed, the entire purchase price is payable. |
| Payment timing | Deferred; paid 1–5 years after closing, depending on goals. | The deal’s last payment. |
| Splitting risk | Buyer: Performance drives pricing, so you’re less likely to overpay. Seller: Riskier since full payment isn’t guaranteed. | Buyer: A failing firm increases the buyer’s risk of overpaying. Seller: Guaranteed and immediate payment reduces risk. |
| Valuation gap | A wonderful approach to narrow value gaps and future projections. | Deadlocks may occur when the buyer and seller have highly different valuation expectations. |
| Seller motivation | A substantial incentive for the seller’s shareholders to ensure the purchase succeeds and meets objectives. | After the sale, the seller’s financial motivation may decrease. |
| Complexity | Complex; requires sound legal wording, measurements, and frequent monitoring. | Simple, fewer paperwork and monitoring after closure. |
| Dispute potential | High likelihood of conflicts over performance calculation, operation interference, and term interpretation. | Indemnification is the main concern following closing, and payment term issues are rare. |
| Buyer cash outlay | As part of earnout calculations, paying less at closing saves money. | Large post-close costs demand strong liquidity from the buyer. |
| Seller liquidity | Slow and unstable cash flow delays complete payment. | The seller receives all funds upon closing. |
| Tax effects | Payments may be capital gains or regular income, affecting tax timing. | Usually simple: the sale proceeds are taxed in the year they occur. |
| Operating control | Buyers desire control, and sellers require influence to succeed, which produces conflict. | The buyer has immediate operational control without performance constraints. |
| Suitable for | Fast-growing enterprises, startups, businesses in unstable markets, and founder-led organizations that require constant involvement. | The benefit of mature, steady, predictable cash flow businesses is evident. |
When are earnouts used in M&A?
Earnouts in M&A are mostly used in circumstances characterized by ambiguity and mismatched expectations between the buyer and the seller. The following are some common examples of how earnouts are employed:
- When a seller has an optimistic view of future performance but the buyer is hesitant to pay for the acquisition in full upfront, earnouts help bridge the valuation gap that exists between the counterparts.
- Earnout arrangements are often used by companies with great future potential, such as high-growth or early-stage product companies, even though profits are still growing or have not yet achieved the success of innovative business concepts. While sellers want to be rewarded for their anticipated success, buyers are unwilling to pay a premium for growth that has not yet been demonstrated.
- In cases where the seller’s continuous engagement (often the founder) is essential for success, an earnout provides an incentive for the seller to drive certain performance targets.
- Earnouts in M&A provide a flexible payment system adjusted to future conditions, which is particularly useful in situations where the market is more uncertain, such as when the economy is unstable or when industries are experiencing rapid transformation.
- Companies heavily dependent on intellectual property or services often rely on the earnout portion to value their prospective earnings in the future rather than merely focus on their current assets.
Key components of an earnout structure
An earnout plan is often a well-constructed merger agreement that has many essential components, including the following:
- The term “earnout period” refers to the timeframe when the earnout objectives should be achieved: from one to five years. Counterparts form an internal term sheet in M&A.
- The specific monetary or operational objectives that form the basis for earnout payments are referred to as performance metrics.
Earnout period:
- Year zero. Closing, purchase price paid, and earnout start.
- Year 1 earnout measurement. The first year of how the business performs is examined; a partial earnout is paid if objectives are fulfilled.
- Year 2 earnout measurement. The second year’s evaluation, possible payout.
- Year 3 earnings. The third year’s performance is examined; the last earnout is based on cumulative or final objectives.
The following are examples of common metrics:
- EBITDA (earnings before interest, taxes, depreciation, and amortization) determines gross profit.
- The net income or profit connects payouts directly to the company’s bottom line.
- Acquisition and customer retention are essential for organizations dependent on subscriptions.
The payment schedule specifies milestone-based payments (for example, yearly or semi-annually), as well as any maximum amount that may be earned (referred to as an earnout limit).
Measurement and reporting specify exactly how to monitor performance, who is responsible for tracking it, and how often reports need to be generated.
Control and operations describe the extent to which the buyer will exercise control over the purchased company throughout the earnout term. These are crucial issues during negotiations because buyers desire operational flexibility and sellers want to preserve control to accomplish their goals.
Provisions for addressing arguments over the attainment of earn-out targets or the reporting of financial information are included in the dispute resolution process.
Benefits of earnouts for buyers and sellers
In the context of M&A fair dealing, earnouts provide both parties with strategic and financial benefits.
For buyers:
- Risk mitigation eliminates initial cash expenditure and ties a significant portion of the purchase price to actual future performance, which mitigates the risk of overpaying for the asset.
- Sellers are motivated to guarantee a seamless transition and continuous development via the use of aligned incentives, which are based on the fact that their future income depends on it.
- Enhanced deal terms make a purchase that would otherwise be costly or risky attainable.
- The due diligence process warrants the buyer’s trust in the seller’s expectations.
For sellers:
- The ability to realize a greater value for the target company in case it performs extraordinarily well enables sellers to negotiate a higher purchase price.
- Enables sellers to attain their target value even if the buyer is initially unwilling to agree to it. This is accomplished via the process of bridging the target company’s valuation gaps.
- Sellers may leave the target company while still leveraging its success through continued involvement.
- Signifies the seller’s optimism in the target company’s prospects and demonstrates their level of confidence in those possibilities.
Risks and downsides of earnouts
Earnouts in M&A, despite their numerous advantages, are not devoid of complications and can pose risks for sellers or buyers.
- Performance-related disagreements
It is common to have disagreements over how metrics are computed, generally accepted accounting principles (GAAP), or the buyer’s strategy on operational actions that affect performance.
- Financial manipulations
Buyers may impact the target business to meet earnout requirements (for example, shifting resources or altering accounting systems). In turn, the sellers, if they maintain control, could exaggerate short-term outcomes at the expense of the target company’s long-term value.
- Failure to achieve set goals
The inability to successfully integrate the newly acquired company into the buyer’s business operations may adversely affect performance, making it more difficult to meet earnout objectives.
- Loss of control for sellers
The seller loses a substantial amount of operational control after the sale, making it difficult to exert influence over the fundamental aspects for achieving earnout objectives.
- Complexity and the burden of administration
Earnout agreements are inherently complicated, necessitating comprehensive monitoring and reporting and increasing the potential for ongoing negotiation and legal expenses.
- Demotivation of the seller’s post-integration
If the seller’s goals seem to be within reach or if the connection becomes strained, the seller’s motivation to execute may decrease.
Legal and tax considerations
Earnouts in M&A transactions present legal and tax issues that require careful consideration.
Legal aspects to consider:
The earnout agreement should be meticulously drafted, with special attention given to clarity for the defining financial metrics, computations, reporting, access to information, and resolution methods related to earnout disputes.
These covenants should prohibit the buyer from engaging in activities that would purposefully or negligently impede earnout objectives. Some examples of such behaviors include asset stripping and diverting important customers.
Buyers will need sellers to make covenants that they will work with them to achieve their goals and ensure a seamless transition.
It requires the implementation of robust procedures (obligatory mediation or arbitration) to prevent litigation.
Initially introduced in the letter of intent, provide accurate financial information leading up to the transaction and are crucial for ensuring representations and warranties.
Taxation aspects to consider:
Earnout payments may be categorized as either capital gains or ordinary income, depending on how the earnout is structured and the extent of the seller’s involvement. For the seller, this implies substantial tax repercussions.
The timing of when income is reported varies, which impacts working capital adjustments, cash flow, and tax planning. For tax purposes, earnouts in M&A differ from other payments. If earnout payments are dispersed over a certain period, the Internal Revenue Service (IRS) has the authority to impute interest expense to the seller, even if the purchase agreement does not expressly specify it.
Earnout payments have the potential to influence the buyer’s tax basis in the assets that were bought, which may further affect depreciation and amortization.
Buyers and sellers alike are required to seek the assistance of knowledgeable legal and tax professionals to successfully manage these challenges and arrange M&A earnouts in a way that is both legally sound and tax-efficient.
How to negotiate a favorable earnout
An in-depth understanding of a business acquisition strategy, coupled with the ability to think strategically and have a profound grasp of the motives, predetermines successful earnout discussions.
For sellers:
- Although you should aim high, you also need to make sure your goals are realistic and attainable. Having objectives that are too ambitious can only lead to disappointment.
- The use of measures that are clear, readily quantifiable, and not easily manipulated by the buyer is what you should pursue. For example, top-line revenue targets should be prioritized above heavily adjusted EBITDA.
- Covenants that restrict the buyer from making operational choices that might impair their ability to meet objectives should be negotiated to protect the target company against the buyer’s interference, including maintaining a specific level of investment, avoiding losing important clients, and retaining key employees.
- Insist on transparent and regular reporting from the buyer, as well as the right to audit their records to verify performance. Clearly define all reporting and auditing processes.
- Ensure a profound earnout dispute settlement framework that is strong, efficient, and cost-effective.
- Be aware of “catch-up” provisions. Certain earnouts contain provisions for a minimum payment even if objectives are missed by a tiny margin or a “catch-up” if early underperformance is subsequently reimbursed.
For buyers:
- Achievable financial targets. When setting goals for the target company, make sure they are ambitious enough to motivate the seller but also realistic for the company to accomplish within your control.
- Operational control maintenance. While it is important to maintain some level of transparency, it is also important to ensure management retention and your ability to maintain operational control to integrate and manage the target company successfully.
- Clear accounting policies. To prevent disagreements, clearly define how performance will be evaluated, including the applied accounting rules.
- Clear strategy. Having a clear strategy for how the acquired firm will be integrated and how it affects earnout performance is an important part of the integration plan.
- Seller’s participation. Determine a desired level of seller’s participation and structure the earnout to encourage their proactive role.
- Risk mitigation. You can limit your total risk by establishing a maximum earnout payout through the use of earnout caps and ceilings.
Earnout clause checklist:
| Clause category | Key considerations |
|---|---|
| Core earnout structure |
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| Payment schedule |
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| Buyer covenants (seller protection) |
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| Seller covenants (buyer protection) |
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| Dispute resolution |
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| Other important considerations |
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Alternatives to earnouts
Although earnouts are a valuable tool, they are not the only approach to bridging valuation differences.
Here are alternative options:
- The buyer receives a loan from the seller for a part of the purchase price based on the assets acquired. This means that the seller is providing financing. Because of this, the buyer may postpone payment, including the seller’s interest.
- A structured payment plan in which the buyer agrees to pay the seller specific sums over a certain period, often with interest. Promissory notes present a structured payment plan. Unlike earnouts, these payments do not depend on the recipient’s future performance.
- Performance-based bonuses (for workers): Instead of attaching a portion of the purchase price to performance, key workers (including the seller) are awarded milestone-related bonuses. This provides an incentive without directly affecting the target’s fair market value.
- Similar to earnouts, contingent value rights (CVRs) are often used in the context of public business acquisitions or for certain future events that are fraught with a great deal of uncertainty (for example, regulatory approval of a pharmaceutical). The holders of CVRs are granted the right to receive future payments in the event that specific milestones are achieved.
- Adjustable purchase price. The original purchase price is set, but there are earnout provisions for modifications depending on post-closing financial success. These adjustments are often based on a defined formula that is less subjective than the conventional earnouts.
- In the case of escrow in M&A, a portion of the purchase price is kept by a third party (the escrow agent) for a length of time. This portion of the purchase money is often used to pay indemnification claims or post-closing changes, rather than for prospective performance.
Key takeaways
- Earnouts in M&A help buyers and sellers bridge value gaps and align incentives, particularly when there is a significant degree of uncertainty or disagreement in estimates.
- The sell-side and buy-side M&A teams should conduct exhaustive due diligence, negotiate all deal structuring aspects, and seek professional legal and tax advice to manage the transaction successfully.
- Although earnouts come with a number of advantages, they also encompass inherent drawbacks associated with post-closing disputes, operational control, and financial manipulation.
