Should Earnouts be a part of the purchase price?

Many business sale and purchase deals I have been involved with had some form of an earnout built into the purchase price.  That doesn’t mean I am a big fan of earnouts, rather earnouts can serve a purpose in transaction negotiations.

An earnout is a delayed payment whereby the buyer and seller agree to a contingent payment based upon future performance criteria.

On the positive side, earnouts allow for a potentially higher purchase price for the business contingent upon the business performing to the levels asserted by the seller.  Earnouts are seller financing but the timing and/or amount of payment is not conclusively known.

Earnouts are often used to ensure that clients are retained and to discourage departing sellers from poaching former clients.  This can be a strong incentive particularly when coupled with a reasonable non-compete agreement.

When the seller is asserting strong growth potential, the buyer may use an earnout clause to reward the seller if the predictions are correct and to keep the price under control if the growth does not materialize.

If there are contingent liabilities that the buyer wants the seller to fund, earnouts can be used to help with those holdback provisions.  For example, when the seller has a pending claim, it is common for the buyer to want an escrow account to hold back part of the transfer price until the claim settles.  Earnouts can provide an additional buffer should the escrow not be sufficient.

But there are negatives for both sides when earnouts are part of the bargain.

  1. The tax treatment requires professional counsel as does the accounting treatment for contingent payments.
  2. The seller may not receive the hoped for proceeds from the transaction, dramatically changing their future plans.
  3. Disputes can arise when the earnout target is missed. e. Did the buyer alienate the client whose retention would trigger an earnout payment?  Was the lack of performance due to unrealistic projections by the seller or poor execution by the buyer?
  4. Client pricing may have to remain consistent even though that means inconsistent pricing between clients.
  5. Integration can be slowed if processes can’t be aligned following the transaction, because the earnout computation requires segregation of revenues and expenses. Clients may not be able to be assigned as the buyer wishes due to the contingent payment.
  6. Earnout computations may not be consistent with the buyer’s accounting structure making the calculation manual and more suspect.
  7. Earnouts can keep the seller from moving on because of their vested interest in the firm. While this may work to everyone’s benefit, there comes a time when the seller should leave and let the buyer steer the ship.
  8. The seller will need to reserve for or have the ability to fund the earnout when due. Since there are rarely escrow funds for this type of contingency, the seller has a credit risk associated with buyer’s ability to make the payment.  Likewise the earnout can be a drag on funding for the buyer’s operation.

If you are considering using an earnout as part of the transaction price do so with an understanding of the complexities the earnout can impose on both parties.  There may be other alternatives that get the parties to an amicable cash price.

photo credit: Andrew Jackson via photopin (license)

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