Earnout Deals Surge in Uncertain Times – What M&A Professionals Need to Know About Earnouts

The M&A market has witnessed a major increase in the use of earnout deal terms after 2021. The number of deals with earnout provisions jumped from around 20% in 2021 to 33% in 2023¹. This trend is likely to continue as earnouts bridge valuation gaps between buyers and sellers, and can be conceptual wins for both sides. 

Increased Use of Earnouts in A Time of Uncertainty

Earnouts commonly refer to post-closing payments to sellers if the acquired business achieves certain negotiated benchmarks at a future time. Buyers agree to pay additional consideration if a business performs as good as sellers project. 

Over the past two years, the market has gone through great uncertainties caused by rising interest rates, expensive debt, inflation and global instability. For potential buyers, transaction expenses are on the rise while confidence level in the performance of target business is questionable. Sellers, on the other hand, tend to view the future of their business in a more positive light, many of whom still hope for the same high valuations from a seller market back in 2020 and 2021. 

The market uncertainties and different expectations of the parties lead to increased gaps over valuation and pricing. By making a portion of the purchase price contingent upon future performance of a business, earnouts have been proven to be a useful tool to bridge those gaps and bring buyers and sellers one step closer to making a deal. 

Operating essentially as a risk allocating mechanism in an uncertain economy, buyers shift more risks to sellers through earnouts by making them show that the business can achieve their projections. In some instances, earnouts serve as a financing vehicle for buyers, allowing them to pay a portion of the purchase price after closing. 

For sellers, earnouts make it easier to transact in a buyer market. While a relatively lower amount of cash consideration paid at closing may be perceived as a downward valuation of their business, sellers now have additional incentives to close a deal with the prospects of sharing profits through earnout payments, if a business performs well post-closing. On the other hand, sellers should be wary of the various contingencies tied to the earnout payments, including how the earnouts are calculated and any other barriers to payment. A recent report found that only approximately 59 percent of deals with an earnout due result in either a partial or full payment.²

Structuring Earnouts – What Are the Key Considerations?

Despite its value in addressing certain risks and valuation gaps, earnout provisions tend to be one of the most contentious areas where post-closing disputes arise. Over 60% of earnout terms use multiple trigger events³, many of the variables, including those seemingly standard terms like GAAP, can be open to interpretation. 

As a result, the design of earnouts is usually heavily negotiated. Earnout benchmarks are often fact- and industry- specific rather than standardized. The choice of earnout metrics, earnout period, post-closing calculations and buyer restrictions all require careful considerations. The following are some of the key items to be on the lookout for in any transaction that employs earnout payments. 

1. Choose earnout measurement metrics carefully and limit judgement calls. 

Earnout triggers are often closely related to key value drivers of the target business. Metrics like new product launches or intellectual property development naturally align with the growth and financial health of the targets. Buyers would have less incentive to diverge from those milestones. However, those growth earnouts can be harder to achieve and are often within buyers’ control. Therefore, parties and their counsel need to carefully consider the implications of their choice of measurements.

Additionally, some earnout milestones such as sales targets, obtaining regulatory approval or those mentioned above, tend to be more objective. The less judgement calls required in earnout decision-making, the less likelihood of disputes arising post-closing.

2. Define ambiguous terms early on.

Ambiguous terms often are inevitable. An American Bar Association study reports that 50%-70% earnout provisions will use EBITDA or revenue as the principal earnout metric. Financial terms can be a major cause of post-closing disputes because of the inherent flexibility in most accounting standards. EBITDA calculation, for example, covers a lot of variables. It will be helpful to lay out the EBITDA metrics in deal agreements, clarifying parties’ intentions as to how it is to be calculated and their underlying assumptions. For example, the parties should clarify whether such metrics are accounted for consistent with historical practice or whether another standard should apply.

Another example would be a requirement of buyer to use “commercially best efforts” to maximize earnout payments. Disputes will arise if it is unclear from the deal documents how different levels of “efforts” are measured. It is always good practice to put some guidance into earnout provisions for terms that are subject to interpretations.

3. Retain control over post-deal operations if possible.

While it is rare for buyers to agree to continue operating the target business in a way that will maximize earnout payments, more buyers are open to restrictive covenants of running a business consistent with pre-closing practices. Sellers should try to negotiate for post-deal operational control whenever possible to lower risk exposure.

An example is the most recent Delaware court decision in Fortis Advisors v Medtronic, dismissing plaintiffs’ claim that the buyer wrongfully deprived them of an earnout payment. The buyer friendly provisions played a key role in this decision. The buyer may act in its “sole and absolute discretion” in the commercial exploitation of certain products. Other language in the Merger Agreement also explicitly acknowledged that the exercise of such discretion may have an impact on the earnouts.

From a drafting standpoint, the language in the Fortis Advisors case left the business decision entirely in the hands of the buyer. Had the seller negotiated for a provision that requires the buyer to use “reasonable efforts” to achieve the earnout goals, the outcome could have been different. While buyers certainly will want to secure a wide latitude in the post-closing operations of the business, sellers should push for preventing acts of omission on the buyer side (including deferring, delaying and refusing to take action), or exculpating buyers for claims or damages arising out of decisions or actions affecting the earnout. At a very minimum, there should be “anti-gaming” provisions to prohibit buyers from acting in bad faith to avoid earnout payments.

4. Think twice when setting the earnout period.

Most earnout periods range from one to three years, with 26 months being the average⁴. Sellers may see a longer timeline as advantageous in that it gives more time to achieve earnout milestones. The other side of the coin is as time increases, so do market and business uncertainties. Depending on the nature and stage of the target business, both parties should carefully consider what the optimal length should be.

5. Consider seller specific vulnerabilities. 

• Buyers may take on additional financing activities post-closing where the lender can prohibit an earnout payment. To avoid any issues, sellers may consider requiring an affirmative covenant of buyer to pre-negotiate approval with a lender. Another option is the pre-negotiation of seller note terms for a higher interest rate that can step up over time – e.g., 6% in year 1, 7% in year 2, 8% in year 3, so on and so forth. In that case even with a lender preventing payment, the seller can still benefit. 
• Sellers need to ensure reasonable access to books and records after the business goes out of their control. It gives seller protection against miscalculation of earnouts or potential buyer manipulation. 
• Although rare, sellers may want to consider anti-sandbagging provisions if a buyer knows of things that will make an earnout unlikely or unachievable.

6. Additional considerations.

• The acquired business may change hands again during the earnout period, yet only about one fifth of the deals would allow earnout to accelerate in a change of control situation. If it is a real possibility, the earnout structure should provide for a solution.
• In a vast majority of deals, buyers negotiate in the purchase agreement an offset for indemnity claims (made against the sellers) against earnout payments. These may be hard to avoid, but such intertwined provisions make it harder to resolve any single dispute when multiple issues arise post-closing.
• In deals where the incumbent management will continue operating the target business post-closing, buyers need to be aware of the possibility that management may sacrifice long-term growth of the business for short-term earnout milestone achievements. 

Conclusion

An earnout is a powerful and efficient tool to make deals happen when buyers and sellers value a business differently. It has become more widely used in recent years to address many of the market risks and uncertainties. The choice of earnout metrics can also be very individualized depending on the transaction and industries. 

While the efforts and time invested into upfront earnout discussions contribute to increased transaction costs and the possibility of heated negotiations, those are negotiations better to have sooner than later. Because of its complexity and uncertainty, disputes over earnouts are one of the most common triggers of expensive and time-consuming post-closing contentions. Carefully drafted earnout provisions will help parties avoid potential litigation and disruption to the business.

¹ 2024 SRS Acquiom M&A Deal Terms Study.
² 2024 SRS Acquiom M&A Claims Insights Report
³ 2024 SRS Acquiom M&A Deal Terms Study.
⁴ 2024 SRS Acquiom M&A Deal Terms Study.