by Tim Moore, CPA, Managing Partner, TR Moore & Company, A Doeren Mayhew Firm
With our M&A Insight panel covering how transactions are getting done in today’s environment only a few weeks away, I thought it was an appropriate time to talk about one strategy that can help prevent a deal from falling apart at the price negotiation stage.
An earnout provision sets a purchase price based on how well the acquired company performs after the deal closes. This allows buyers to pay less up front and sellers to potentially receive a higher amount than they otherwise might.
But earnouts can be complicated. Before you agree to structure your transaction this way, acquaint yourself with the risks.
Benefiting Both Parties
With an earnout, buyers pay only a portion of a company’s total purchase price at the deal’s closing. The balance is paid in installments as the acquired company achieves specific performance metrics and milestones that the seller and buyer have agreed on.
These milestones might involve performance in:
- Revenue
- Net profits
- Cash flow
- Earnings per share
- Level of capacity utilization
- The launch of new products or the acquisition of new customers
Appropriate Earnout Period
Deal participants must agree on an appropriate earnout period based on how long both parties project it will take to adequately measure the company’s performance and reach a total satisfactory estimated transaction payout. An earnout period that’s too short may encourage managers, in pursuit of short-term profitability, to neglect aspects crucial to the business’s long-term success such as product quality and customer service. But an earnout period that’s too long may drag out the process unnecessarily and delay payment to the seller.
Once performance metrics and milestones for the earnout have been set, deal participants should address potential issues that could impede the company’s ability to reach these goals after the acquisition is complete. These include a changing competitive landscape or a large-scale economic downturn. To protect against these events affecting future payments, sellers might want to consider negotiating alternative methods of measuring the company’s future performance in the earnout agreement.
When it Makes Sense
An earnout can be a good solution when sellers are confident that their company’s future performance will meet or exceed projections. Sellers, however, likely will want the company to be operated as a stand-alone unit during the earnout period. If the buyer is planning to fully integrate the acquisition into existing operations, it may be difficult to separate various functions, such as accounting and the allocation of expenditures, and to isolate performance — which will be necessary if the company is to reach the earnout agreement’s benchmarks.
While earnouts can net a higher price in the long run, sellers need to consider the possibility that they will never receive more than the closing price. The buyer could default or the company’s future performance could fail to meet the agreement’s terms. Though protections such as money in escrow or a letter of credit are options, sellers should think twice about an earnout unless they’re willing and able to accept only the initial amount.
Earnouts can be attractive to buyers who might not otherwise be able to finance a larger up-front payment. The buyer also may reap the benefits of a seller who’s motivated to reach operational or financial milestones and increase the value of the company.
Potential Power Struggles
Significant power struggles between parties also are possible. Sellers generally want input into how the company is run to help ensure it will meet performance targets. They can do this by structuring the earnout to require their consent to any significant business decisions, such as the sale or acquisition of major assets or the termination of key personnel. Buyers, on the other hand, desire the freedom to steer the business in the direction of their choosing and will want to ensure that the earnout provides them with the authority to do so.
The parties can head off another potential conflict by making sure the earnout agreement includes specific guidelines for the calculation of performance measures. A seller may choose to define control provisions in the purchase agreement to ensure buyer performance. The buyer, likewise, can implement control provisions to ensure contributions by the seller during the earnout period. The agreement also should address accounting matters that could cause discord down the line, such as allocation of the buyer’s corporate overhead, depreciation and taxes, and extraordinary events.
Sellers also should insist on protections in the event the buyer attempts to undermine the company’s performance to avoid payments. Accurate accounting and auditing methods can be tricky during an earnout, and the seller should define a process and schedule for reviewing and assessing performance as part of the purchase agreement.
Buyers, for their part, should negotiate provisions that preserve their economic interest in the business. If the seller maintains management control after the acquisition, the buyer may, for example, want to request the right to mandate the reduction of expenses if the business isn’t meeting its targets. Buyers also should be careful when agreeing to protective provisions that could force a barrier between the acquired business and other business units. This could lead to greater expenses that potentially diminish the benefits of the acquisition.
Heading Off Trouble
Earnouts can be a useful tool in getting a deal accomplished — but they aren’t without risk. Careful negotiation, attention to detail and comprehensive documentation can go a long way in eliminating risk and help achieve terms that lessen the odds for legal disputes in the future.
Tim Moore is managing partner at TR Moore & Company, where he also leads the firm’s Mergers & Acquisitions Division. To hear more insight on how buyers and sellers are bridging the price gap, register for M&A Insight 2011, where Tim will speak on a panel along with leaders from Main Street Capital Corporation, Haynes and Boone, and North Carolina investment banking firm Fennebresque & Co.
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