The Problem with Earnouts
by Roger Royse
Despite the warnings from lawyers, many deals get done with earnouts. An earnout is contingent purchase price consideration that gets paid only if the target hits certain negotiated milestones. The earnout is thought to limit the buyer’s risk by pegging the purchase price to performance, and also ensures that the selling shareholders will have an interest in ensuring performance post close. It all sounds good until we get into the details. The tension is that a buyer normally wants maximum flexibility, in particular to shut down a target’s business if things don’t go well without risking a lawsuit for target shareholders based on a claim that they were prevented from hitting their numbers. The milestone can either be (and often is) either based on gross revenue, EBITDA (earnings before interest, taxes, depreciation, and amortization), or some adjusted income calculation. From a seller’s standpoint, gross revenue is a convenient and easy measure because it does not lend itself as easily to manipulation, like net amounts do via acceleration of costs, deferring gains, or improperly allocating costs and expenses. However, from a buyer’s point of view, they are usually after net numbers. A buyer may prefer net amounts since gross numbers can be propped up by spending more on marketing, which they might not want to do.
Using GAAP defined terms is convenient, but often risky. Startup company targets are not often GAAP – compliant, and may be surprised at what EBITDA is under their historical method of accounting as compared to what it is under GAAP. As a result, even when GAP terms are used as the metric (Net Income, Margin or EBITDA), there should almost always be carveouts and exceptions for certain historical practices. In addition, and more subtley, a buyer will often integrate a target’s business into their own for operating and scale efficiencies. That restructure will require allocations of general overhead and possible enterprise software or other costs. A well thought out earn out agreement will anticipate those allocations and restrict a buyer from improperly using allocations to reduce earnout figures.
Sometimes an earnout is too closely tied to the selling shareholders employment to qualify for capital gain treatment. Generally, contingent purchase price is still purchase price, and if other requirements are met, the proceeds are taxed at the 15% federal capital gain rate instead of the ordinary income rate (up to 35%). An earnout that looks more like performance compensation, however, may not qualify for the lower rate. Care should be taken and tax reporting expectations should be set (and agreed upon). Although compensation treatment is bad for sellers, a buyer has a post close interest in treating contingent payment as immediately deductible compensation, and absent an agreement will have the power to report it that way, so this is not an issue that should be left ambiguous.
The bigger issue often relates to the operation of the business post-closing. A savvy seller should ask for contractual protections to ensure that the buyer operates the business in a manner that is designed to maximize the possibility of achieving earn out goals, or at least to not operate the business in a way that reduces their chances. For example, a seller would want the buyer to covenant that they would not reduce divisional staff size, and would continue to expend similar dollars on support and marketing as they the sellers did pre-close. A seller may want to ensure that they will continue to have a hand in operations post close, or to accelerate payments if they are involuntarily terminated.
It is also in the buyers’ interest to spell these issues out in advance, since they may have an obligation to operate the business in a way that allows the earnouts to be achieved. The only realistic way to restrict that obligation is to set specific performance guidelines and standards.
Unfortunately, this area has lent itself to litigation. Buyers may claim that the earnout targets have not been met and sellers will claim that the buyers prevented them from being met. A well thought out and crafted earnout provision can minimize the risk of expensive litigation. This is one place where a bit of planning can save a lot of trouble.
For additional information on legal issues, contact Roger Royse.