Earnout Structure

  • Peter Lynch

Earnout Structure

Properly structuring an earnout in an M&A or private equity transaction requires carefully evaluating each of its components. In this post, we will explore each relevant variable. This description will include a lot of variations, which may feel overwhelming if you are new to earnouts. To provide context, we will introduce a concrete example after this description.

Target: The metric that must be achieved for earnout compensation to be granted. Some common examples focused on company performance include achieving a certain level of revenue growth, earnings growth, margin expansion, customers added, service or production levels reached, assets divested, regulatory hurdles cleared, patents granted, etc.

In addition, targets may also be linked to buyer return thresholds (e.g., exceeding a 20% IRR or a 2.0x MOIC). Frequently in private equity transactions, attaining EBITDA thresholds that mirror the seller’s management projections are used as a benchmark.

Incentive: The type and amount of compensation granted when the target is reached. In some cases, this may be just a simple cash payout (funded with company cash, an additional equity infusion by the buyer, or in some cases additional financing). How an earnout is funded will depend on the company’s financial prospects, ownership structure, and the owner’s timeline at the point the earnout comes due. In other cases, this may be equity grants or other similar variable structures (for example, a 5% equity interest in the company or 20% of equity value above a certain base return).

Duration: The trigger point at which the target is tested. In some cases, this may be linked to a definitive period (e.g., 6 months or 3 years), and in others, it may be contingent upon the occurrence of some milestone event (e.g., a subsequent sale of the company or refinancing or, if a life science transaction, FDA approval or similar milestone).

Complexity and Payout Structure: The number of levels or “steps” in the earnout. In some cases, there may just be one (e.g., “$10 million paid after 3 years if earnings double in that period”). In other cases, the earnout may involve two or more steps, with varying targets, durations, or both. One example of a multi-step earnout with varying targets would be “$10 million paid after 3 years if earnings double or $15 million paid if they triple.”

Similarly, an example of a multi-step earnout with varying durations “$10 million paid after 3 years if earnings double and an additional $5 million paid after 5 years if they increase by an additional 50%.”  Depending on the structure, the earnout payment may be made in one lump sum or through multiple payments at certain time intervals as thresholds are met.[1]

Definition and Scope of the Acquired Business: The performance of the business is often a key component in determining whether an earnout is achieved; therefore, when structuring an earnout it is crucial for both the buyer and the seller to clearly define the businesses and the scope of what may or may not be done to alter its performance and financials during the term of the earnout.

Buyers should seek to define what portion of the business is to be measured in determining whether the earnout threshold has been met. This can often include schedules defining which product lines will be included in the calculation of the earnout, whether or not new product lines developed will count towards the calculation, and more.

Protection of Post-Acquisition Control:  The buyer will want to ensure that the provisions of the earnout, whether the seller is involved in the future management of the company or not, do not prevent the buyer from operating/improving/growing the business as they intended to in their investment thesis. Buyers should seek sole and absolute discretion to operate the business as they see fit. To the extent the seller is to stay involved as a member of management at the company, the buyer should ensure there are provisions to verify that revenue is not being artificially inflated and/or operating expenses are not being reduced in such a way so as to improve the short-term financial outlook to the detriment of the long-term performance of the business. Sellers should seek clarity into the ongoing performance and any changes within the company that may impact their receipt of the earnout. This is often referred to as provisions related to the “implied covenant of good faith and fair dealing”.

In many cases, the seller will seek to structure the provisions of the agreement to prevent the buyer from making material changes that would impact the performance of the business; these changes could include discontinuing historical business lines, price reductions on core products, changing product names, and much more. Sellers may even attempt to stipulate that the buyer must continue to operate the company in accordance with past practices for the duration of the earnout period, invest certain amounts in R&D or marketing, etc.  Naturally, the differing viewpoints can lead to conflicts of interest in negotiations.  For this reason, core checks and balances such as the seller’s right to access the financial reports of the company – at varying intervals and with varying levels of detail – are put in place to offset some of these concerns.  Negotiations of earnout provisions can be time consuming and costly and by the same token, litigation is not unusual.

Seller Earnout Examples

Multiple of EBITDA Earnout:

Earn-Out. The Sellers shall be entitled to receive an additional amount (the “Contingent Payment”) equal to (i) seven (7) multiplied by (ii) the amount, if any, that the EBITDA during the Contingent Payment Period exceeds the EBITDA Target.  Notwithstanding the foregoing, in no event shall the Contingent Payment exceed $10,000,000.

“Contingent Payment Period” means the two-year period commencing on [________________].

Excess of EBITDA Earnout:

Earn-Out. Sellers would be entitled to receive 25% of the Company’s EBITDA in excess of $XX,000,000 for each of the first five (5) years following the transaction. The Earn-Out will be subject to a netting concept: if the Company’s EBITDA falls below $XX,000,000 in any year, then this difference must be achieved in addition to the $XX,000,000 in EBITDA in subsequent years for the Earn-Out to have a positive impact. To the extent that there is an acquisition, these figures would be modified in a manner mutually agreeable to both parties.

Footnotes:

[1] Certain earnout structures often require a cap to the total payout. There may also be additional language clarifying whether indemnification claims offset earnout payments.

Note: ASM is developing a new series focused on earnouts as part of our Content Creation Initiative with Katten. Over the next few weeks we will develop a course that explains how earnouts are structured and modeled. 

ASM Content Creation Initiative