A Lawyer's Thinking on Earnouts

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When selling a business, one will likely be approached by multiple buyers, all of which may propose different purchase structures. A few of the most common purchase structures are:

  1. Cash – the buyer transfers cash (often characterized as “immediately available funds”) from its account to the seller’s account.
  2. Seller Financing – the seller acts as the bank for the buyer. The seller issues a loan to the buyer and the buyer uses the financing from the loan to purchase the business. Sometimes parties find this arrangement faster and easier than having the buyer work through a third party to obtain financing.
  3. Debt Financing – similar to seller financing, but in this instance, the buyer obtains the loan from a third party, not from the seller.
  4. Equity Financing – instead of receiving cash for the sale, the seller receives equity interests from the buyer (these equity interests are usually interests in the buying entity, but can be interests in other related entities, such as a parent or holding company).
  5. Cash + Earnout Arrangements – the buyer pays some of the purchase price in cash at the closing and some of the purchase price is deferred and paid-out over time (usually 1 to 3 years post-closing). The deferred payments are generally contingent upon the post-closing performance of the business.

Structures 1 through 4 are the most common methods used by buyers and sellers in today’s market. Additionally, because of their prevalence, many feel comfortable drafting and negotiating the documents and provisions outlining such. In this article, I focus on structure 5 (Cash + Earnout Arrangements), as it is becoming more prevalent in certain industries and many business principals and advisers are unaware of certain key items to consider when drafting and negotiating such arrangements.  

The earnout structure is a way for the buyer of a business to allocate risk between itself and the seller. There are many reasons why a buyer may wish to structure a transaction to include an earn-out -- three common reasons are: (i) the business being acquired has an uncertain future and the buyer is unable to predict how the business will perform following the sale (this could occur for instance where the seller has, prior to the sale, entered the business into high-risk agreements or taken on burdensome financing terms), (ii) the business is very dependent upon “handshake” agreements and close relationships built by the seller and it is unknown if the buyer will be able to maintain those relationships post-closing, and (iii) the buyer is unable pay the total purchase price for the business at the closing and sees an earnout as a way to provide additional payment at a later date. 

It is rare that a seller would propose an earnout structure. Generally, a seller wants the purchase price to be paid as soon as possible. The seller may propose an earnout structure if: (i) the seller and buyer are related or close contacts in some way, (ii) the seller is looking for the sale to serve as a retirement plan of sorts, and sees the periodic payments akin to those of an annuity, or (iii) the seller sees the business as having a higher value than that of the buyer and is seeking this deferred/contingent purchase price as a way to “prove” that the business is worth more (i.e. the seller is better on itself).   

The following is an example that will help illustrate this discussion: Assume Owner A is selling Business A to Buyer B. Owner A and Buyer B agree on an earnout structure for payment of the purchase price. The agreement is as follows: (i) at the closing Buyer B will pay to Owner A $1,000,000 in cash, and (ii) on January 1 of each year for the 3 years immediately following the closing date, Buyer B will pay to Owner A 10% of the net income of Business A for the preceding 12-month period.

In most sale transactions, the purchase price is set and determined prior to the closing (with a potential purchase price adjustment to follow). In the earnout context, the purchase price has two components: the fixed payment and the variable payment. As seen above, the January 1 payments are the variable payments. Here are a few things to keep in mind when “variability” enters the purchase price structure:

  1. When the purchase price is dependent upon certain future business metrics being achieved, the seller will likely have the potential to earn more than would otherwise be possible if the purchase price were completely fixed. The seller is being compensated for taking on the risk that the business does not perform post-closing. In this example above, this would mean that the seller should feel reasonably certain that the three earnout payments are adequately compensating him/her for taking on the risk of how the business performs over the next three years.
  2. It is important for all parties to make clear (i) who will be making the calculation that determines if earnout payments are made (in the example above, this is the calculation of net income), and (ii) how the calculations that determine the amount of such earnout payments will be made (such as an agreed-upon formula for the parties to follow). It is important that all parties are aware as to how the calculation process will proceed to ensure that there is no ambiguity regarding this process and that post-closing calculation disputes are avoided.
  3. The seller should keep in mind what control, if any, it desires to have over the business during the earnout period. It would be wise for the seller to have some control over the business during this period, as the seller’s financial future is dependent upon how the business performs over this time. If the seller has no control of the business, he/she could be forced to stand on the sidelines while its business is driven into the ground or operated in a way that decreases the potential of earnout payments. In the example above, it would be prudent for Owner A to request some sort of employment agreement for the three years following the closing to ensure that he/she is able to influence and appropriately manage the business to give himself/herself the best chance to earn the deferred portion of the purchase price.