A New Age for M&A: Investing in Economics and Law: Earnouts
By Derin Kulbul
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EARN-OUT MECHANISMS
Earn-out agreements are executed between the seller and the buyer of a company and indicate that “the seller of a business will receive future payment(s) from the buyer contingent upon the business meeting specified performance targets or achieving certain financial goals.” The main purpose of the agreement is to encourage the sale when a gridlock has occurred regarding the sale price. Sellers can be more easily convinced of a sale if they are promised benefits in the future dependent on the business’ performance. The involvement of lawyers in the drafting of the agreement typically addresses few key elements of the agreement:
- Defining the performance metrics from which the earn-out will be determined
- Drafting the agreement
- Any dispute resolution arising from the agreement
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Defining the Performance Metrics
In deciding the metric on which the payout will be based, sellers often prefer revenue-based metrics because they are less influenced by expenses. Whereas buyers prefer income performance metrics because they indicate the success of the business better. The various financial performance metrics including net revenues, EBITDAs, net incomes, balance sheet items etc. are often decided through a negotiation process between the buyer and the seller. Once the metric is determined, a threshold for when the earn-out will be awarded is set, and the manner in which the performance metric will be calculated is established, the parties will agree on whether the payout will be a fixed percentage or a variable percentage. Since the mathematical elements of the earn-out agreement can spark discussions and fall-outs due to the varying interests of the seller and buyer, a legal disputes team may be necessary to foster healthy negotiation.
Drafting the Agreement, The Valuation of Earn-Outs
Once the numbers have been established, a time period for the earn-out should be determined. Since disagreements about the earn-out period between the parties can occur, a disputes resolution team may be utilized. In deciding when the earn-out period will end, the buyer will prefer for it to be as short as possible to minimize the duration of shared management. However, the buyer may also prefer for the period to be longer to ensure that the required payout can be financially made without compromising business objectives and traditions. As for sellers, a shorter earn-out period can result in an earlier potential payout and the value of the payout will decrease as time goes on. The ‘two sides of a coin’ aspect of earn-out mechanisms often requires lengthy discussions.
Additionally, the ownership and degree of control to be accorded to the seller and the level of support required from the buyer are factors which often require negotiations before finalizing the contract. Maintaining a balance between the buyer’s desire to run the business and the seller’s desire to protect the business is a gruesome process with many areas open for dispute.
Disputes Arising from the Conclusion of the Agreement
The earn-out mechanism is not complete with the conclusion of the contract. The agreement can lead to disputes if the business fails to meet the target, the seller claims that the payout calculation was wrong, the buyer breached the agreement or breached an implied covenant of good faith and fair dealing. In such cases, courts must interpret the provisions of the contract and consider the intention of the parties. The disputes may be solved by arbitration rather than litigation if the parties wish for a decision to be reached faster.
In conclusion, due to the room for disagreement over the agreement regarding the payout calculation, the period it will be in use, the degree of control to be afforded to the seller and the expectations of support from the buyer, the agreements often need to be very precisely and carefully drafted to prevent future misconceptions and disputes.
