Earnouts Can Help Cement a Business Sale, But Beware of the Risks

Earnouts are pricing structures, often used in private business sales, by which part of the purchase price is deferred until after closing. It becomes payable only if the target business meets certain agreed-upon financial benchmarks or operational milestones during a specified period. Earnouts can be useful in overcoming obstacles to a business sale. However, they must be carefully crafted to protect sellers against future risks and disputes. 

Earnouts are helpful where the buyer and seller are unable to reconcile their views on the present and future value of the target company. Buyers often express caution in accepting upfront valuations of the business, since post-transaction performance can be difficult to predict. Conversely, sellers may be unwilling to accept a depressed valuation based on current market conditions. Earnouts can bridge this valuation gap. If satisfactory performance is achieved, sellers are compensated accordingly, while buyers are shielded from overpaying should projections fail to materialize.

Earnouts can be based on a range of performance metrics, calculated in accordance with Generally Accepted Accounting Principles (GAAP). The most common ones include revenue, gross profit, EBITDA (earnings before interest, taxes, depreciation, and amortization) and net working capital. Non-financial or operational milestones might include the launch of a new product, entering into key commercial agreements or achieving regulatory approvals. The agreement must specify the measurement period (often one to three years post-closing), the method of calculation and the timing and amount of potential earnout payments.

Earnouts can pose risks and pitfalls, however. Since the seller’s eventual compensation depends on how the business is run after the acquisition, disputes can arise if the buyer takes actions that inadvertently (or intentionally) depress performance metrics. For example, altering accounting policies, reducing operational investment or integrating various business units might skew results and affect payment triggers. 

To mitigate these risks, earnout agreements should be meticulously negotiated and drafted. Common covenants in these agreements include requirements for the buyer to operate the business in the ordinary course, to maintain specified levels of investment or staffing or to refrain from diverting key customers or revenue streams from the target to other ventures. Some contracts may grant the seller limited oversight or consultation rights during the earnout period or require the buyer to provide regular financial reporting.

In view of the potential for post-closing disagreements, careful drafting of earnout agreements is essential. Both parties benefit from clear, objective criteria for performance measurement, explicit reporting obligations and well-defined dispute resolution mechanisms. The agreement should anticipate and address foreseeable operational changes, providing that neither party can manipulate results to unfairly increase or decrease earnout payments.

If you are the seller, an experienced business purchase and sale attorney can help structure earnouts to balance risk and reward, minimize ambiguity, protect your interests and ultimately enhance the likelihood of a successful transaction without post-closing disputes.

The Law Offices of Donald W. Hudspeth, P.C. advises on purchases and sales of companies of all sizes. From our office in Phoenix, we represent clients throughout Arizona. Call us at 866-696-2033 or contact us online to schedule a consultation.