Earnout provisions can be an effective tool for addressing the potential disconnect between a seller’s expectations and a buyer’s ability to pay when negotiating a business combination transaction. Earnout provisions, or contingent purchase price agreements, allow buyers to limit their upfront payment and spread the purchase price over time. From the seller’s perspective, earnouts can provide an opportunity to receive additional compensation based on the future performance of the acquired business. Despite these advantages, there are a number of issues to consider when negotiating the language of earnout provisions.
What is an Earnout?
An earnout is a contractual clause that provides for payment of an additional amount of money beyond the initial purchase price, generally tied to the future performance of the business. The amount of additional payment is often tied to specific performance milestones, such as revenue growth, profit margins and customer retention.
Things to Consider When Drafting Earnout Provisions
Although earnouts can be beneficial to both buyers and sellers, there are several issues to consider when negotiating the language of earnout provisions. First, the parties should clearly define the performance milestones and the payment terms. This includes setting a target performance level and establishing a timeline for when payments will be made. For example, the target performance can be based on monetary milestones. Earnouts based on revenue generation, for example, would permit the seller to earn a bonus payment based on the total revenue for the business over a specified period, and paid in installments over a period of time, with a portion being paid at the end of each year. Milestones could also be based on the business’s profit margin going forward. In such an arrangement, the seller would earn a bonus payment based on the profit margin of the business over a specified period. Earnout payments based on profit margins are typically paid in a lump sum when the profit margin milestone is achieved. Alternatively, earnout milestones may be tied to non-financial metrics. For example, an earnout provision may be based on customer acquisition, whereby the seller earns a bonus payment based on the number of new customers acquired over a specified period. The bonus payment may be paid in installments over a period of time, with a portion being paid at the end of each year. The earnout could also be based on employee retention, whereby the seller would earn a lump sum bonus payment based on the percentage of employees retained over a specified period.
Second, the parties should decide who will be responsible for calculating the earnout payments and how disputes will be resolved. For calculating earnout payments, the parties should:
- Set a clear definition of what constitutes success for the buyer and seller, whether utilizing financial or non-financial metrics.
- Establish the timeline for when the earnout payment will be triggered.
- Establish the performance metrics that will be used to measure success. This could include things like revenue, profit, customer acquisition or other key performance indicators.
- Set a formula for calculating the earnout payment based on the performance metrics. This could include things like a percentage of revenue, profit or other agreed-upon criteria.
- Establish the payment terms for the earnout payment including when it will be paid and how it will be taxed.
If the buyer and the seller dispute whether a particular milestone has been achieved, the exclusive process for addressing and resolving such disputes (expedited arbitration, mediation, etc.) should be set forth in the definitive agreement. The parties may establish consequences of not following the dispute resolution process, such as financial penalties or other punitive measures.
Third, the parties should consider how the earnout payments will be taxed. Sometimes, earnout payments are taxed as ordinary income, just like any other type of income. However, the amount of the tax liability may depend on the specific terms of the earnout agreement. In some cases, the payments may be treated as purchase price consideration (i.e., capital gains) and taxed at a lower rate. The IRS may also require the parties to the agreement to apportion the payment between capital gains and ordinary income. To determine the proper tax treatment of earnouts, an owner should consider the owner’s employment term relative to the earnout period, the owner’s post-closing employment compensation, and a buyer’s earnout obligation if the owner’s employment is terminated. Ultimately, parties should enlist the service of knowledgeable tax professionals in connection with structuring the earnout provision to ensure that they receive the most beneficial tax treatment for their unique circumstances.
Finally, the parties should consider how to protect the seller’s interests if the buyer terminates the agreement before the earnout payments are made. Some examples include:
- A liquidated damages clause in the acquisition agreement, whereby the buyer would agree to pay the seller a specified amount of money if the buyer terminates the agreement before the earnout payments are made.
- A “no-shop” clause, drafted to prevent the seller from soliciting or entering into any agreements with other potential buyers while the acquisition agreement is still in effect.
- An “anti-dilution” clause requiring that the buyer maintain the seller’s ownership stake in the company in proportion to the original terms of the agreement.
- A “clawback” provision, allowing the seller to recover the amount of the earnout payments if the buyer terminates the agreement before the earnout payments are made.
- Require the buyer to provide a letter of credit or other security to the seller to guarantee the payment of the earnout payments.
Conclusion
Earnouts are becoming increasingly popular in M&A transactions, as they provide a way for buyers to limit their upfront payment and spread the purchase price over time. When negotiating the language of earnout provisions, it is important to carefully consider the performance milestones, payment terms, dispute resolution, taxation, and protection of the seller’s interests. When drafted properly, earnouts language should result in either a win-win for both parties or serve as a protective intervention tool if the deal doesn’t go as planned.
