M&A Monday: The Power and Risk of the Earnout
How to use an Earnout, major negotiation points, and why the Earnout is a Litigator’s best friend.
Many PE and Independent Sponsor deals use an Earnout and many Searcher deals (funded by SBA 7a debt) have forgivable Notes. Earnouts are not allowed in SBA 7a funded deals (for a deep dive into the mechanics of forgivable notes see https://x.com/Eli_Albrecht/status/1724081900803731800; and how to get a seller comfortable: https://elialbrecht.substack.com/p/m-and-a-monday-how-to-get-a-seller).
This post will discuss the Earnout, when to use it, tips for constructing an Earnout, common negotiation points, and a warning for those inclined to deploy the Earnout.*
The Earnout is a portion of the purchase price that is not paid at closing, rather at a future date and contingent on a future occurrence. It can be simple one time payment upon an occurrence or complex based on milestones and multiple future dates.
A. When to use an Earnout. If there is an assumption that impacts the Target’s valuation, but it is unclear whether that assumption is true, consider an Earnout. E.g., Target’s financials are unstable, but Seller wants an offer based on last year’s financials that were 30% above average (e.g., EBITDA averages were 2022: $5m, 2023: $5m, 2024: $6.5m). Or there is a customer concentration issue, but Seller wants an offer based on all those customers staying on after closing. Another example (less common) could be a key employee staying on after closing or even Seller staying on for transition services.
B. Constructing an Earnout. The Earnout should be the amount of purchase price value attributed to the uncertain assumption. Dig down until you hit bedrock – the bedrock should be your non-contingent purchase price, everything above should be Earnout. In our 30% above average financials example, the Buyer should take the average of non-outlier years (let’s say, $5m) and that should be the non-contingent purchase price ($30m (at 6x EBITDA)). Then, take the outlier amount (let’s say, $1.5m) and attribute an Earnout to that amount ($9m (at 6x EBITDA)). The same can be done with key customers, key employees, transition services, or anything else.
C. Key points of negotiation. Adding an Earnout adds about 20% to your negotiations. All of the key aspects of the Earnout will be negotiated: (i) Earnout amount, (ii) measure for the earnout and definitions (e.g., revenue, EBTIDA, gross profit), (iii) threshold for earning the earnout, (iv) when it is calculated, and (v) when it is paid. These terms will have a direct economic impact and are heavily negotiated.
In addition, operating covenants are heavily negotiated. Operating covenants govern how the new buyer can run the business after closing. Buyers hate to be restricted in how they can run the business, but the seller needs to make sure the buyer is maintaining the same level of employees, marketing, expenses (if relevant), and behaving in a way that maximizes the earnout. At a minimum, buyer should be willing to give a covenant stating, they will not take any action [direct/indirect] to decrease [that has the effect of decreasing] the earnout (this single is one of the most heavily negotiated aspects of an earnout) (i.e., business judgment carveout).
Sometimes the consequence of breaching a covenant is the attribution of phantom Earnout (what would the earnout be if the covenants were not breached). Other times, there is a full acceleration of the earnout if a covenant is breached.
Another issue is whether seller can remain in control or at least, involved during the earnout period to ensure the earnout is earned. What if seller is fired during the earnout period? For Cause/leaves with Good Reason?
There are tens of other negotiation points.
A couple of other considerations.
Indemnification Offset. The Buyer will want to be able to use any earned Earnout for offsetting indemnifications.
Tax point: the purchase agreement should specifically state the Earnout is an increase to the purchase price for the tax benefits of additional purchase price payment. We consult closely with our Chair of Transactional Tax, Josh Siegel on this point.
Complexity. Finally, two words of immense caution. First, Earnouts are extremely complex and there are hundreds of variables. If your lawyer is not skilled, this could cost you real money. This also adds about 20% in complexity to your deal and expect it to take longer.
Finally, as a Partner at my prior law firm once told me, an Earnout is a Litigator’s best friend. Be ready to either pay the Earnout or litigate this issue down the road. Save your negotiation discussions and document redlines, because you may need it. If you are engaged in a dispute, you can reach out to our Litigation Group, headed by Travis Ritter.
*There is great debate about the spelling of the “Earnout”. Some spell Earnout, some Earn Out, or Earn-out. It is just important to be consistent.