The Earnout

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Reasons for Having an Earnout

A significant problem for the acquirer is a seller that insists upon a valuation that is based on future expectations for the business. For example, the target company may be “just a few months” away from landing a major new contract, or launching a new product, or opening up a new distribution channel. The seller may believe that these prospective changes will have immense value, while the acquirer rightfully feels that these future prospects are entirely unproven, and may never occur or generate additional cash flow. These differences of opinion can cause major differences in the assumed valuation of the business.

When future expectations are causing a difference of opinion regarding valuation, one solution is to put off the acquisition until such time as the projected change has occurred, and its impact appears in the financial statements. However, these changes may take months or years to be completed, and may never occur at all. If so, the two entities are never able to close an acquisition deal.

An alternative that bridges the valuation gap between the two parties is the earnout. An earnout is a payment arrangement under which the shareholders of the target company are paid an additional amount if the company can achieve specific performance targets after the acquisition has been completed. It has the following advantages:

Payment source. The improvements generated by the target company will likely generate sufficient cash flow to pay for all or a portion of the earnout, so the acquirer may be cash flow neutral on the additional payment.
Target achievement. The shareholders of the target company will push for the completion of the performance targets, so that the acquirer pays the earnout. This helps the acquirer, too (despite having to pay the earnout), since the results of the target company will have been improved.
Tax deferral. The shareholders of the target company will be paid at a later date, after the earnout is achieved, which means that the income tax related to the earnout payment is also deferred for the payment recipients.

Problems With Earnouts

Despite these advantages, an earnout is generally not a good idea. The trouble is that, even after purchasing it, the acquirer must leave the target company as a separate operating unit, so that the target’s management group has a chance to achieve the earnout. Otherwise, there is a considerable risk of a lawsuit in which there is a complaint that the acquirer’s subsequent actions to merge it into the rest of the company impair any chance of completing the earnout conditions. It is risky for the acquirer to leave a newly acquired company alone in this manner, since doing so means that it cannot engage in any synergistic activities designed to pay for the cost of the acquisition – such as terminating duplicate positions or merging the entire business into another part of the acquirer.

Further, the management of the acquired business will be so focused on achieving the earnout that they ignore other initiatives being demanded by the acquirer – and the acquirer may not be able to fire them for insubordination until the earnout period has been completed. In short, agreeing to an earnout clause subjects the acquirer to an uncomfortable period when it cannot achieve its own goals for the target company.

This does not mean that earnouts are impossible, only that they should be very strictly defined. Here are several tips for mitigating the issues associated with them:

Earnout period. Keep the period over which the earnout can be earned as short as possible, so that the acquirer does not have to wait too long to enact its own synergy-related changes.
Continual monitoring. Have a performance tracking system in place that keeps all parties aware of the progress toward the earnout goal, so that no one is surprised if the goal is not reached. This lessens the risk of a lawsuit, since expectations were managed.
Sliding scale. Pay the earnout on a sliding scale. For example, if the target company achieves 80% of the target, it is paid 80% of the earnout. This is much better than a fixed target, where no bonus is paid unless an exact profit figure is achieved. In the latter case, the shareholders of the target company are much more likely to initiate a lawsuit, since they are not paid at all even if there is only a slight performance shortfall.