Wait! Before You Go…

An earnout provision in mergers and acquisitions contracts entitles the seller of the target company to additional compensation in the future if the target performs well after closing. Such a provision is often used when a gap exists between the buyer’s lower valuation and the seller’s higher valuation. Essentially, it is a way for the buyer to say, “if you think your company is really worth as much as you say it is, prove it.”

As a simple example, company A is buying company B. Company B is fairly new but has averaged $20 million in annual earnings over the last three years. Company A agrees that B’s seller will continue to help manage B for two years and, if B averages at least $30 million in earnings in the two years post-closing, then A will pay B’s seller an additional $10 million.

It may be obvious to any armchair psychologist or economist, but this basic earnout structure is fraught with likely disputes. As one court put it, “since value is frequently debatable and the causes of underperformance equally so, an earnout often converts today’s disagreement over price into tomorrow’s litigation over the outcome.” Airborne Health, Inc. v. Squid Soap, LP, 984 A.2d 126, 132 (Del. Ch. 2009). Some obvious problems include:

1. Company A’s desire for control: Company A will likely want to be involved in the management of Company B after spending millions of dollars to purchase B, which will lead to managerial friction between what A sees as prudent and what B’s seller sees as its managerial freedom to run “business as usual.”
2. Company B’s seller’s disincentives: Company B’s seller can be disincentivized to make B as profitable as possible if, for example, it appears that an earnings target is impossible due to external factors in the market or B’s seller believes that she can get richer by focusing on her other projects rather than B’s success.
3. Accounting issues: The definition of earnings is often misunderstood between the parties or manipulated when accounting time comes, whether due to the carryover of expenses from one period to another, applying certain deductions from earnings, or otherwise.
4. Integrative cost savings: Company A will probably expect to benefit from economies of scale by integrating Company B into A’s ecosystem of accounting, marketing, credit, or other shared services, which A will see as reducing B’s overhead, but B’s seller might interpret as derailing B from business as usual.

These and other problems often lead to distraction, B performing below A’s expectations, B’s seller blaming A for interference with and underperformance of B, and A blaming B’s seller for failing to dedicate sufficient effort to making B profitable. This is an environment in which litigation thrives.

What is needed to avoid these problems, if A and B’s seller are convinced that an earnout structure is necessary or advisable? In a word: clarity. The parties must consider the incentives each will have and create clear expectations, definitions, and boundaries. Referencing the problems noted above:

1. As to Company A’s desire for control, the parties can specify the extent to which A will be involved in B’s management during the earnout period. This is more easily said than done. For example, in addressing a post-earnout management provision that required operation of the business “in all material respects, consistently with how the [seller] operated it before the closing and/or how the [seller] suggests operating it,” a court lamented that the provision “is a classic case of ambiguous language in a contract—and a recipe for protracted litigation.” Horowitz v. Nat’l Gas & Elec., LLC, No. 17-CV-7742, 2021 WL 4478622, at *13 (S.D.N.Y. Sept. 30, 2021). Getting this right—and contractually unambiguous—requires time and effort before closing.
2. As to Company B’s seller’s disincentives, the parties can create audit systems to track B’s seller’s time and effort, build in a sliding scale of earnout payments depending on B’s performance during the earnout period rather than using an all-or-nothing incentive, and specify when B’s seller can be replaced due to lack of effort or failure to perform.
3. As to address accounting issues, Company B’s profitability metrics must be defined clearly to avoid disputes during the earnout period. For example, are GAAP standards going to be followed religiously, or will there be exceptions; will an identified third-party auditor confirm the profitability calculations, or will they be done in house; how will interest, taxes, depreciation, and amortization be treated; and so on.
4. As to integrative cost savings, the parties can define precisely the extent to which Company A will provide shared services to B, the extent to which any such services, or incorporation into A’s ecosystem, is at B’s seller’s option, and how shared services will affect B’s profitability from an accounting perspective (for example, whether Company B is charged for the shared services for earnout purposes).

In addition to all of this, the parties must also consider formalizing a minimum level of communications and streamlining dispute resolution to avoid years-long litigation when disagreements arise.

In short, earnout agreements, while often a near necessity to bridge valuation gaps between the parties and to transition Company B profitably to Company A, are fraught with risk and often result in disputes. Parties should carefully anticipate risks and precisely contract for as much clarity as possible to govern their relationship during the earnout period and to appropriately incentivize both sides.

Author: Jared Wilkerson