Earnouts: Where sellers should spend their negotiation capital

This story was originally published by Law360™ Canada, (www.law360.ca) a division of LexisNexis Canada Inc.

By Charlie Kim, Matthew McGuigan and Sebastien Tuli

In mergers and acquisitions (M&A) transactions, there is a constant struggle between the vendor and purchaser regarding risk allocation. This tension often arises from uncertainty regarding future performance, issues identified during due diligence and disagreements regarding value. One common mechanism for bridging that gap is an earnout, which makes part of the purchase price contingent on the post-closing performance of the target business.

For owner-managers, however, the first earnout question should not necessarily be how to maximize the earnout. Rather, the seller should assess how much of the purchase price they are prepared to leave contingent, if at all. A seller may decide that greater certainty is worth giving up some potential upside.

What is an earnout

An earnout provides for part of the purchase price to be determined by the post-closing performance of the target business. Earnout triggers can be financial, such as earnings before interest, taxes, depreciation and amortization (EBITDA) or revenue, or non-financial, such as customer retention, regulatory approvals or development milestones.

For example, a purchaser might offer $12 million for a business, consisting of $10 million of non-contingent consideration and up to $2 million of additional consideration based on EBITDA performance over the following two years. Depending on the structure and the results achieved, the seller may receive all, some or none of the $2-million earnout.

Certainty before upside

When a purchaser proposes an earnout, an owner-manager should first identify the minimum amount of non-contingent consideration they need to be comfortable proceeding with the transaction. That amount is not the seller's minimum valuation of the business. Rather, it is the portion of the purchase price the seller is not prepared to expose to future performance risk.

Once the seller identifies the amount of certainty it needs, it can negotiate toward that objective. For example, a seller may ultimately prefer to trade some of the potential upside of an earnout for greater certainty by negotiating a lower headline price that maximizes the amount that is guaranteed. Such a trade-off may reasonably bridge the gap between the parties.

From the seller's perspective, it may be rational to forgo a higher headline price for more certainty. After closing, some or all of the factors affecting the earnout may be outside the seller's control. The purchaser may integrate the business, change sales strategies, allocate costs differently, invest for longer-term growth or make other legitimate business decisions that adversely affect the earnout. The risk is not limited to purchaser misconduct; the purchaser may simply run the business differently than the seller would have.

Seller-specific safeguards

In most circumstances, if the seller is willing to accept an earnout, it should assume that any dollar that is paid through the earnout is subject to decisions regarding a business they no longer control. The seller should therefore focus its negotiating capital on protections that address the particular risk of uncertainty. These may include:

1.Operating covenants: restrictions on actions that could adversely affect the earnout, such as diverting customers or revenue, discontinuing a material business line or shifting opportunities to affiliates;

2.Calculation methodology: clear rules governing the applicable metric, including accounting policies, expense allocations and adjustments, together with an independent dispute-resolution mechanism;

3.Information rights: access to relevant books, records and periodic financial or operational information during the earnout period;

4.Acceleration: making some or all of the earnout immediately payable upon specified events, such as a subsequent sale of the business or certain purchaser breaches; and

5.Payment protection: where appropriate, guarantees, escrow arrangements or security to serve as comfort that the purchaser will be able to make the contingent earnout payments when required.

Negotiation tactics for owner-managers

The foregoing safeguards should not be treated as a checklist. The seller should instead identify how the earnout is most likely to be affected in the particular transaction and prioritize its negotiating capital accordingly. The seller should be cognizant of the following when negotiating earnouts:

1. Bargaining power: An important aspect of negotiating is assessing your relative bargaining power. If the power dynamic is tilted towards the purchaser, the seller should be strategic in selecting the safeguards it chooses to negotiate, focusing on those that are most important so as not to expend significant negotiating capital.
2. Involvement post-closing: In many transactions, the purchaser may keep owner-managers on as executive employees during the earnout period. Where the seller remains involved in day-to-day management, they may retain more influence over decisions that affect whether the earnout target is achieved, thus requiring fewer safeguards than a seller who exits the business completely after closing.
3. Know your purchaser: Understanding how the purchaser intends to operate and integrate the business can help sellers identify which safeguards are most important. For instance, if a purchaser intends to integrate the target business quickly, protections around expense allocations, diversion of revenue and accounting methodology may take on greater importance. The purchaser's track record with prior acquisitions and similar earnout arrangements may also be informative.

At the end of the day, drafting can only provide so much protection for a seller. Ultimately, the seller's comfort level in accepting an earnout will come from the trust they build with the purchaser through the negotiating process and based on the purchaser's track record.

Conclusion

For an owner-manager, maximizing the purchase price does not necessarily mean maximizing the headline number. The better starting point may be to determine how much of the purchase price must be non-contingent to make the transaction worthwhile, and then decide how much potential upside the seller is prepared to leave at risk through an earnout.

Once that allocation is settled, the seller can focus on protecting the contingent portion. Sometimes the best use of negotiating capital is not to squeeze more potential dollars into the earnout, but to move the dollars that matter most outside it.

If a seller is willing to accept an earnout, it should consider its specific circumstances carefully before negotiating seller-friendly safeguards. Sellers sometimes have a limited amount of negotiating capital, and they should deploy this capital strategically to achieve the most possible certainty.

The opinions expressed are those of the author(s) and do not necessarily reflect the views of the author's firm, its clients, LexisNexis Canada, Law360 Canada or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.