NVCA Today

In response to the volatility that has permeated virtually all markets, sellers and buyers increasingly are turning to earnouts to reach agreement on pricing. Earnouts can help accommodate different views about the long-term value of a business, but also add complexity and a basis for disputes. Earnouts may have incidental effects, such as incenting seller employees who were shareholders of the seller to work effectively at the buyer after closing. Earnouts also allow the buyer to use the earning power of the target to help “fund” the acquisition, at a time when more traditional sources of funding remain elusive.

Earnouts thus may allow parties to reach an agreement today, but they require careful consideration and structuring.

Structure and Terms

An earnout generally refers to an additional payment (or payments) of purchase price that the buyer makes after the closing, but only if the target business achieves specified milestones. The terms of the earnout are determined by the parties through up-front negotiations and specified in the acquisition agreement (with some potentially significant exceptions, as noted below).

There is no “standard” earnout formula. An earnout can be structured in a wide variety of ways, depending on businesses, risk tolerances and other characteristics of the parties. Choices of terms can include differing triggers, mixes of closing and potential post-closing payment amounts, adjustments for performance that falls short of, or exceeds, a milestone (for example, structuring payments to be either proportional to the target’s achievement of the milestone or subject to a “cliff” where no payment is made if the milestone is missed), and forms of payment. An earnout also can incorporate different operational covenants and other features.

Several of the key terms are discussed below.

Triggers. A key element is the milestones that the target business must achieve to trigger the earnout payment. Milestones ideally should be based on events or results that are clear and not subject to interpretation. The most appropriate triggers generally depend on the specific attributes of the target business, including the type and stage of development of the business. The level at which the milestone is set, and the spacing of multiple milestones, are typically the subject of extensive negotiations, with some parties seeking “home runs” and others seeking to reward more measured, but steady, performance.

Common financial milestones include specified levels of sales or EBITDA and other income statement items. Calculation of these items, however, can be subject to the discretion that is allowed under accounting rules and other interpretation. Accordingly, when using a financial milestone, parties must consider the accounting method by which the milestone will be measured. Many earnout transactions include some description of the accounting rules that will be used in measuring the target’s post-closing performance, determined by the parties with reference to the target’s prior accounting practices or some other mutually agreeable principles.

Earnout milestones also can be based on non-financial developments, such as regulatory approval of a new drug or expanded use for an existing drug, or a new product, or the achievement of a distribution or other marketing relationship.

Duration. The length of the earnout period is also a key element. For a financial milestone, for example, the parties may desire a period that is long enough to minimize the effect that volatility in the operations or financial results of the target business may have on the earnout.

Impact on Indemnity Limits. The parties should specify the interaction between the contractual indemnities and the earnout payments. For example, if the buyer has sought indemnities in excess of the agreed limits on the sellers’ indemnity obligations, will the buyer be able to set off future earnout payments against the excess losses?

Multiple Classes of Stock. Target companies with different classes of equity interests, such as a VC-financed company with one or more classes of preferred stock, present additional challenges. In some cases preferred holders, if their potential payments are limited to their preferences, may be better off converting their preferred shares to common stock, depending on the amount of the earnout that will be actually earned and available for payment to the common stock, but it will be difficult to predict at the time the acquisition agreement is signed.

Such uncertainties also can make it more difficult for the target company to obtain the approval of the common shares for the acquisition (at least in states or for companies where a separate vote of the common is required by statute or governing documents), since depending on the relative size of the initial payment and the earnout, the common may not be getting very much of the initial consideration.

Post-Closing Control of the Business

One of the most controversial issues in negotiating earnouts is the control of the target business during the earnout period. To maximize the opportunity to achieve the earnout, the seller often will want to ensure that the target business can be operated in substantially the same manner as it was conducted prior to the sale and that the buyer is obligated to provide some minimum level of support to the target business, such as with respect to R&D or capital budgets, marketing expenses and other costs, and to avoid competing products and other acts that might cannibalize the target business.

The buyer, on the other hand, will want to be able to integrate the newly-acquired business into its operations as efficiently as possible, respond to changes in circumstances, and take advantage of other opportunities. Buyers thus argue for greater flexibility, while targets want commitments.

These provisions also can address the incentives that may otherwise flow from other earnout terms. For example, if the earnout trigger is based on sales, then the parties will want to ensure that appropriate resources are allocated to promoting sales (which will help the target reach the milestone), but also (particularly from the buyer’s perspective) that other beneficial aspects of the business, such as R&D, are continued. The buyer also will want to restrain the former sellers from agreeing to sales terms that are overly generous to customers but that enhance top-line revenues.

Potential for Implied Obligations. The parties also should consider the obligations that may be implied in the absence of specific language. While these implied obligations reflect some common themes, they generally are a matter of contract law and thus vary from state to state. For example, in a recent case (under Massachusetts law), a court implied a duty for the buyer to use reasonable efforts to develop and promote the target company’s technology, despite the absence of any such requirement in the purchase agreement.[1]

Tax, Accounting and Regulatory Concerns

Depending on its structure, the tax treatment of the earnout may vary, including the recognition, timing and characterization of the seller’s taxable income generated by the earnout.

A buyer subject to US GAAP must consider the impact of FAS 141(R), which now requires the buyer to record the “fair value” of the expected earnout as of the closing date, rather than wait to see when the earnout becomes determinable. FAS 141(R) also requires the buyer to true up the amount reserved for the earnout as the probability of making the payment changes, which can make the buyer’s earnings during the earnout period more volatile.

Parties should also consider whether the seller’s right to payment under the earnout would be treated as a security for US securities law purposes. If the right to payment were treated as a security, the offering of that right would be, in the absence of an available exemption, subject to the registration requirements of the Securities Act of 1933.

Related Payments and Other Issues

Using an earnout makes the amount of actual purchase price payments difficult to predict, which affects other determinations made in connection with the acquisition. For example, the variability and timing questions can complicate any calculation of “fair value” when contemplating whether to exercise dissenter’s rights that may arise under applicable law.

Disputes

Using earnouts often leads to disputes. While the parties may be willing to agree on an earnout to reach agreement on the overall acquisition, they later may disagree over the interpretation of a milestone or the measurement of the target business’s performance, the support the buyer was obligated to provide, or whose “fault” resulted in the failure of the earnout milestone to be met.

Recognizing the potential for disputes, parties often negotiate specific dispute resolution mechanisms. Many buyers also reserve the right to “buy out” the earnout by paying some specified amount regardless of the performance of the target business.

If the target had multiple shareholders, the parties also may want to establish a mechanism whereby one shareholder (or sometimes a third party) is appointed to make decisions on behalf of the target shareholders with respect to any post-closing disputes, as well with respect to the conduct of the target business (similar to the mechanism typically provided for negotiating and resolving disputes with respect to post-closing indemnity claims).

Conclusion

With the continued uncertainty in the market, and the increasing need for buyers and sellers to come to terms, the use of earnouts is increasing, and the relative amount of the purchase price to be paid through the earnout also is going up. The days when an earnout represented only the “icing’ on a deal are gone. At the same time, parties are becoming more creative and flexible in structuring earnout provisions.

Ultimately, whether an earnout should be used to bridge a gap in price negotiations will depend on the benefits and risks for a particular M&A transaction. In some cases, it may be more appropriate for both parties to simply focus on agreeing on the price for the acquisition without use of an earnout.

Michael O'Bryan is a partner and a co-chair of Morrison & Foerster LLP’s Mergers & Acquisitions Group.