Earnouts in M&A Transactions: A Valuable Solution in an Exit Strategy

There are many unique challenges and opportunities that arise as technology companies and their founders are planning for exits or other significant merger and acquisition (“M&A”) transactions. One powerful tool often used by buyers and sellers during the transaction negotiation process is the “earnout.” An earnout is a commonly used incentive in M&A agreements where additional purchase price payments are contingent upon the performance of the acquired business after the deal is closed. The consideration of this additional compensation is in lieu of including the money upfront in the purchase price, resulting in the sellers only receiving the compensation after meeting certain financial and/or operational goals. An earnout can serve as a helpful solution when the buyer and seller struggle to agree on an initial cash price, acting as a bridge between their differing valuations. Earnouts may also provide the benefit of additional time when the buyer and seller are eager to close but don’t have every detail of post-close net working capital tied down. However, despite these benefits, an earnout clause has the potential to spark disagreements between both parties regarding whether the agreed upon target is achieved. The target is often based on a financial metric, such as revenue, EBITDA, or net income. Occasionally, the target is based on a non-financial metric such as the retention of key employees or customers.

Buyer vs. Seller Perspectives

From the buyer’s perspective, an earnout offers several advantages. First, earnouts allow the total acquisition price to be tied to the future performance of the acquired company, mitigating the risk of overpayment based solely on projected performance. Additionally, earnouts can serve as incentives for the seller’s management team to maintain operational excellence post-acquisition.

Sellers, on the other hand, typically prefer upfront cash payments but may consider an earnouts under certain conditions. For instance, sellers are often concerned about the achievability of milestones, the buyer’s operational interference, and ensuring adequate support for the business’ success. A seller’s agreement to an earnout clause can suggest that they have confidence in the future of the operating entity, serving as a qualitative factor that makes the deal more appealing.

Structuring Earnouts

Properly structuring an earnout in an M&A or private equity transaction requires careful consideration of several critical factors, such as:

1. Financial Metrics: Determining which financial metrics (such as EBITDA or gross revenue) will trigger earnout payments.
2. Time Period: Defining the time frame over which the agreed upon milestones must be achieved. In most cases, the established period spans one to three years.
3. Graduated or All-or-Nothing Payments: Deciding whether payments are all-or-nothing or graduated based on varying levels of milestone achievement.
4. Protective Provisions: Negotiating buyer obligations to operate the acquired business in good faith, maximize earnout payments, and provide ongoing support.

Given the fact that rapid innovation and continued expansion and growth are essential in the tech sector, earnouts may offer a strategic solution for aligning the goals of buyers and sellers in M&A transactions. However, earnouts often lead to disputes, therefore establishing a clear mechanism for dispute resolution is essential. Anchin recognizes the nuanced perspectives of both sellers and buyers and strives to navigate these complexities to facilitate mutually beneficial agreements that foster long-term success for all parties involved. Anchin’s expertise includes the structuring of earnout clauses specific to tech companies and their founders, as well as the related valuation and accounting considerations associated with this strategy.

To learn more about earnouts and how they can benefit your business, contact Chris Noble, Partner and Leader of Anchin’s Professional Services and Technology Groups, or Adam Pizzo, Partner.