Merger & Acquisitions Earnouts Explained
Hi everyone, this is Brett Cenkus the right-brained business lawyer and a business consultant and this video is a video about mastering M&A. It’s specifically about earnouts in the M&A context or what I call getting paid later. Now, I’ve talked and written about different ways to get a purchase price. Obviously, everyone knows what a purchase
price is. In the M&A context, when you sell a business the buyer pays for the business- that’s the purchase price. Now, the purchase price can come in different forms. It can be partly cash, partly seller financing, it could be in the form of stock of the buyer of the business so now you have their paper. If they’re a public company, hey that’s great there might be a little bit of a lock-up period where you can’t sell that stuff but after that it’s freely tradable. It’s easy to realize cash on it. If it’s a private company who knows. I have to give you their paper, their stock. It may be a long time until you can find a buyer for that or until that company goes public or gives you an opportunity to realize cash for those shares.
That’s all about different forms of the same set purchase price, different ways you can receive the purchase price and they carry pros and cons. Earnouts are more about variable purchase price. So with an earnout, if the business performs in a certain manner – hits certain metrics in the hands of the buyer – after the closing the buyer will pay the seller an additional amount or amounts depending on the structure. So, the business literally earns the purchase price. The business in the hands of the buyer earns the purchase price for the seller or very commonly, and we’ll talk more about this in a few moments, the seller or seller’s will go with the business and they’ll actually work the business continuing in their roles, continuing in their same positions for the buyer and actually earn additional compensation post-closing.
So, the earnout is about a variable purchase price and it’s fundamentally about sharing risk. It’s about aligning the incentives of the seller and helping the buyer with some of the risk that comes with buying a business. Buying a business carries a lot of risk, the data is out there. Half of these are public company mergers and acquisitions but half of them fail to realize positive shareholder value. So, buying a business is risky and you might know everything about your business, you might even have the buyer be involved with you in some manner. The buyer might be a customer, a supplier or something but they still don’t really know what it’s going to be like to buy your business.
So, an earnout is a way to help them share risk. From your perspective, I know you want to be paid today, everyone does. You want to be paid the maximum amount right now in cash, yet that’s not always possible. So, I think you should warm up to earnouts for two main reasons.
For one, it might allow you to receive more money. You shouldn’t have the exact same purchase price if you were paid in cash versus your expectation on an earnout – that’s not a fair sharing of risk. You’re taking some risk for the buyer and you’re helping stay committed and show your commitment to the business post-closing. You should have an opportunity to earn more than you would otherwise.
Number two is you simply may have to accept an earnout to have any opportunity of selling your business. This is particularly true when the business fundamentally carries the transfer of considerable risk. That might be the case because you have significant customer concentration, you kind of have one or two customers or the business clearly operates around you – you’re really fundamental to it. There are things that a buyer is going to be thinking. “Look I might want that business, but it’s just way too risky if you aren’t dialed in, seller.” If you’re not working and helping me realize value or if I lose that one big customer I’m in a lot of trouble as a buyer so I might force you to take some of that risk and the market might force you take some of that risk, too.
Let’s say you decide that an earnout makes sense for you. You either have to deal with it or you decide, hey I can make more money this way. Be very, very careful over earnouts where you’re not going with the business, where you don’t have control over the business post-closing. So, if you sell to an individual and you go sip cocktails on a beach while the individual runs it the risk is quite simple. You have no idea how that individual will perform, whether or not they’ll treat the business like you did, whether or not they’ve got the ability to grow that business. There’s that risk of who’s performing if it’s not you.
If you sell to a larger business you have that same risk, but you have additional risks when you sell to a larger business. They already have product lines and service lines and departments and divisions and all that stuff. You’re just going to be one more business over there. Having a lack of control carries an additional risk not just that they might not perform as well as you, but that they might chop your business up. They might move part of it over here, they might put someone in who’s very expensive, they might, say, look at that division, you know, your business, in the hands of corporate after closing, needs to bear some of this corporate overhead. Everyone’s paying some of the executive salaries at the corporate level, so they’re going to push down operating expenses that change the profit and loss of the business. It might still be growing the top line – the revenue – but not growing the bottom line.
So, on that point, earnouts come in all sorts of different flavors but fundamentally the business needs to achieve certain metric. I’ve worked on them where you have to have a certain amount of customer attention, certain amount of employee retention, certain amount of revenue retention, certain amount of revenue growth, certain amount of EBITDA (which is earnings before interest, taxes, depreciation, and amortization – it’s a measure of profit). You could come up with any of these things but if you do the bottom line
EBITDA or earnings, net income, then any corporate overhead that’s being pushed in there, the corporation’s take it from another division. If the parent company takes overhead expenses and puts it in this division, the business you’ve sold to them, that’s going to lower the bottom line, reduce the profits and that might be just fine for them but it’s not just fine for you.
So, earnouts work best if you go with the business, if you’re going to continue to run it then you want to be very careful to negotiate as much as you can in the purchase agreement about how that earnout is going to work. You want to ensure that you have control over the profit and loss statement, that any corporate overhead is limited to a certain amount of corporate overhead. They shouldn’t be pushing in new expenses and things like that. You could talk about things like acceleration, so you would want ideally an employment contract. The earnout employment period is two years, which is pretty common, three years, sometimes more than that but it’s fairly rare. So, in a two-year earnout you would want a firm employment agreement. You don’t see employment agreements a lot in private companies, but you would negotiate for one that says you can’t let me go, Mr. Buyer or Mrs. Buyer unless you pay me out for the earnout unless it’s for cause or certain other things that they would have a right to let you go. But otherwise you want to have control. You want to have certainty that you’ll be there. You want to have some protections that the parent isn’t going to push other expenses down there, that they won’t make decisions on your behalf for how the business should run that affect you. Include successful provisions that say things like, to the extent buyer takes an action that should reasonably be deemed as impeding the ability of the seller to earn the earnouts owed.
So, you want to kind of get in the weeds and figure this stuff out. You may think, “okay this is great. I’m selling my business, I have a chance to earn more money.” That all works in your favor, but the devil’s in the details on those earnout provisions. Make sure that you’ve got the control you need, that the buyer isn’t playing games or just doing what they do to run the rest of their business without a lot of concern about whether or not you hate your metrics.
These things I’m talking about are way down in the weeds but they’re super, super important so don’t gloss over them. They’re going to be highly negotiated. The buyer will say, “we’re buying the business, it’s ours to run, we can’t agree to all those things,” but they will sometimes. It just depends, and you want to negotiate as much as you can. I’m not suggesting most buyers are going to be unfair, but they’re just not as concerned as you about actually getting paid that earnout. In fact, they’re quite a bit less concerned. They want the business to transition well which is why earnouts work. They align interest and share risk, but they don’t necessarily need you to hit that particular metric for them to still define things as successful.
So, you’ve got to get in the weeds on that stuff but warm up to earnouts. They’re a great tool to align incentives. They might make your business a lot more marketable. If you’ve had problems with earnouts I’d love to hear from you. If you think they’re the greatest thing ever I’d also like to hear from you. On that, thank you for stopping by today.