The Enduring Earnout in Middle Market M&A

The Continued Use of the Earnout

Today’s market continues to demand high valuations for sellers, but buyers bring with them doubts about the economy and future growth. With these conflicting needs, you have the perfect environment for earnouts. Many companies have shown recent growth and margin but, Buyers remain skittish. One solution to a valuation disconnect is to use an earnout to bridge the gap.

The first two quarters of 2024 have seen a continued strong use of earnouts. The 2024 Deal Terms survey by SRS Acquiom showed that more than one-third of all transactions had an earnout as part of the consideration. This number is down slightly from 37% of transactions in 2023, but it signals that buyers and sellers continue to need to find ways to bridge valuation gaps.

As a result, negotiating terms of an earnout is a large part of the overall transaction conversation. 

Decide on the Driver(s) of the Earnout

Buyers and sellers continue to get creative on the structure and unit of measurement for earnouts. Benchmarks are typically financial (revenue, gross margin, or EBITDA), but they can also includes items such as customer or employee retention or growth.

Sellers – if the driver is financial, you’ll want the measurement unit to be as close to the top of the income statement as possible. Revenue is least likely to be impacted by changes made by the buyer, is relatively easy to measure, and more difficult to manipulate.

Buyers want assurances that the business is performing well and will often look for measures like profitability or EBITDA margin.

Agree on the Measurement of the Earnout

Be as specific as possible – if you can list ledger accounts to put into the formula, do that. Attach examples in the document with specific accounting principles called out. Robust definitions and examples are key to future earnout success.

It is also important to clearly lay out selling shareholders ability to receive information and the accounting for the earnout determination. Sellers with access to information and the ability to communicate with the buyer post-transaction are less likely to have a conflict related to the earnout.

Discuss the Timing of the Measurement Period and Payment Terms

If the earnout is measured over multiple years, determine if a seller can make up ground for a year if the earnout level was not met. For example, if the seller was $100,000 short in earnout year one, but is $200,000 over in earnout year two – some agreements allow the dollar amounts to be averaged or even shifted to the prior period. This can eliminate the need to “force a sale” before the year-end (and annoying a customer) or penalizing a seller for other timing issues.

The SRS Acquiom survey found that the 81% of earnouts were longer than one year. The most popular time period (41%) is between one and two years.

Decide if the earnout is paid once the threshold has been met, (this is usually preferred by buyers) or is paid out on a sliding scale. Sellers advocate for a “graduated” approach where the seller receives a specific percentage of the target as it is achieved. 

Buyers prefer an “all or nothing” approach – meaning once the target is met – the earnout is paid. This can be especially harsh. Think about missing the earnout threshold by $10 or some small amount.

A compromised approach is to use a graduated earnings approach only after a threshold is met.

Does the Earnout Have a Cap?

An earnout with unlimited potential can be especially attractive to sellers. In some cases, sellers may be leaving a customer relationship with upside or have a new product in development. These situations are hard to project and an unlimited cap on the earnout can be an attractive way to get a seller to contemplate a transaction on the business today versus waiting.

Most earnouts have caps or a maximum that a seller can earn. The idea of unlimited purchase price due to a seller in the future would be difficult to project for buyers. Most want some certainty around any future payments.

No Longer Owning the Business Can Impact an Earnout

A Company that reliably generated cash flows and sales growth historically, may not continue to do so after a sale. It is unlikely that a seller will be able to influence decision making to the extent they have in the past. For example, a buyer may increase expenses for new personnel or software. A buyer may not sell the same way a the previous owner had. A Buyer, if private equity, may impose management fees on a business. 

On the other hand, a buyer that invests in the business may provide a better platform for hitting earnout targets because of the influx of resources.

A Seller needs to pay attention to specific clauses regarding how the business runs post-transaction.  SRS Acquiom found that:

• 3% of transactions required a buyer to run the business in a way that maximizes the earnout payment
• Only 3% of transactions included a covenant for the buyer to run the business consistent with past practices
• 23% of transactions included a provision that accelerates payment of the earnout upon a change of control
• 70% of transactions expressly allow a buyer to offset indemnity claims against the earnout payment

With the Rise in Earnouts, We Are Seeing an Inevitable Increase in Disputes

Unfortunately, not all earnout thresholds are achieved. With the continued popularity of earnouts, there is a corresponding rise in disputes around payment.

In 2023, Bloomberg Law studied federal and state court documents searching for the words “M&A,” “mergers and acquisitions,” and “earnout.”  The number of court cases since 2022 has risen significantly.

Harvard Law’s Corporate Governance review found that the number of disputes related to earnouts may be inflated, but are increasing in the middle market. That same Harvard Law study found that Delaware courts have recently ruled in favor of sellers.

“While Delaware law principles applicable to earnouts set a high bar for sellers to succeed on earnout-related claims, and while historically the judicial trend was in favor of buyers, in six of seven recent major earnout decisions—including, most recently, FLMS v. Integris BioServices (issued October 31, 2023)—a Delaware court found in favor of the seller seeking earnout payments. This recent trend may put more pressure on buyers to settle rather than litigate earnout disputes. It is to be noted, however, that the Delaware courts continue to emphasize the specific agreement language and factual context—and, thus, the outcome in earnout cases tends to be highly uncertain.”

Harvard Law School Forum on Governance

Best Practices for Drafting an Earnout Provision

To avoid a dispute related to an earnout is to start with well-written language in the purchase agreement.  Simply having legal and/or accounting terms correctly identified is usually insufficient to stop problems.  Put protections in place with regard to measurement, payment, and access to information.

To protect a transaction from litigation, make sure the investment bankers and lawyers drafting the earnout understand the business and its market. This is another example of why investment bankers with specific industry knowledge can give a transaction greater likelihood of success. The more business-specific language included in the earnout definitions, the more secure the provision.