Turning to Earnouts - A potential solution for negotiation stalemates

Sometimes merger and acquisition negotiations reach
an impasse — even when both parties are committed
to making the deal succeed. When buyers and sellers
are at loggerheads over pricing, all of the transaction’s
benefits can fall to the wayside.
There may, however, be an alternative: an earnout.
With an earnout agreement, the seller might remain
with the company to operate it after it has been sold.
The buyer agrees to make periodic payments to the
seller if the company meets specific performance goals.
Incentives for everyone
An earnout can be a particularly effective way to bridge
the gap when the buyer and seller disagree about the
value of the company. The promise of future payments
can assuage seller concerns that they’re settling for a
price that undervalues their business. And, assuming
the seller remains in control of operations after the
sale, earnouts help reassure the buyer that the seller
will work hard to maintain the company’s performance.
Keep in mind that earnouts are far more effective for
sellers when, postmerger, the selling company
continues to operate as a stand-alone subsidiary or the
seller continues to manage it as a division of the
acquiring company. If a target is intended to be
immediately absorbed by the buyer, earnouts may not
make sense. Sellers will have little control over the newly
merged company’s performance. Negotiating the details
Although earnouts often provide a solution to difficult
price negotiations, the process of agreeing on an earnout
structure can prove challenging as well. The parties need to
discuss the form that seller payments will take as early
as possible, because this decision can have other ramifications. If, for example, a seller wants to be paid
in stock, the parties must decide whether the stock will
be valued as of the deal closing date, at some other
date or by another measure.
The parties also must agree on the objectives that must
be reached to trigger earnout payments and an
acceptable accounting method (typically, Generally
Accepted Accounting Principles) by which to measure
achievement of these objectives.
Earnout objectives could include:
Sales. Often, sellers prefer that performance be
measured by gross sales, because they provide a clear
goal that management can directly influence.
EBITDA. If performance is measured by EBITDA
(earnings before interest, taxes, depreciation and
amortization), the seller will need to show that it’s
achieving a certain level of pretax cash flow. Earnout
payments typically are a percentage or multiple of the
amount by which the seller division’s results exceed a
set EBITDA figure.
Annual performance. The parties may agree to set an
annual performance threshold based on revenues.

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