Earnout 101: The Role of Earnouts in M&A

When buyers and sellers can’t agree about the final sale price, your M&A firm may recommend a compromise: an earnout. Earnouts delay some portion of the final sale price contingent on ongoing performance by the business, usually by requiring that the seller/owner meet certain performance benchmarks. If you’re considering selling your Dallas business, know that an earnout is a powerful tool to bring to the negotiating table. But it also poses significant risk, and is not appropriate for all deals.

In general, an earnout includes three key components:

• The specific, usually financial, goals the business must meet before the seller can receive additional compensation.
• The timeline under which the seller must meet these goals, and the specific accounting assumptions used in measuring benchmarks.
• The amount of compensation the seller will earn—often a percentage of total additional profits.

So is an earnout right for your deal? Here’s what you need to consider.

The Basic Structure of an Earnout

The specific structure of any given earnout varies, but in general, it includes a lump sum paid at closing, followed by specific sums paid contingent on meeting certain benchmarks. These sums may be paid at regular intervals, or as one final sum at a specific end date. The more specific the earnout clause is, the fairer it is likely to be. Unclear benchmarks, vague language about success, and other common pitfalls can significantly disadvantage the seller, allowing the buyer to claim the seller has not met the requirements of the earnout and is not entitled to additional compensation. Earnouts are a common source of post-closing litigation, so it’s important to ensure a skilled M&A attorney looks over the agreement to protect both parties.

Emerging Earnout Trends

Earnouts can keep a deal on track that might otherwise have crumbled. As a result, they’ve grown in popularity in recent years, driven in part by the increased role of private equity firms in M&A. One recent American Bar Association survey found that around 27% of recent deals involved earnouts. The one-time financial hit to many industries from COVID-19 likely plays a role in this trend, as businesses continue to recover and attempt to protect against future uncertainty.

Once something becomes a trend in M&A, though, it tends to stick around, even when the original impetus (in this case, COVID) disappears. Sellers should be prepared for increasingly stringent earnout provisions, and must consider whether the potential increase in earnings in the future is worth the loss of a payout today. In many cases, an earnout may be the only leverage a seller has for driving up the sale price, especially if a buyer has other options. As we move into a potential recession, both parties must be prepared to make concessions.

Getting Earnouts Right

As with all other M&A undertakings, getting an earnout right requires getting the right advice. This is not a time for a DIY approach. The right M&A firm can help you decide whether an earnout is appropriate, and how best to structure one.