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By Joel Weinstein

Los Angeles, CA

Buyers and sellers of businesses often use earnouts to resolve pricing differences. An earnout is a contractual obligation that increases the amount paid for a business if performance milestones are met. Earnouts also encourage sellers who remain with the merged business post-closing to continue supporting the company. It is important for the earnout to be set at a level that the sellers feel is achievable, and that the purchaser is comfortable paying.

The parties should take great care in crafting the earnout. The earnout provisions should specify in detail the following: (i) the performance goals that trigger the earnout obligation, (ii) the accounting methods that will be used to determine whether the earnout has been achieved, (iii) the inclusions and exclusions from the earnout calculation, and (iv) the method for resolving disputes about whether the earnout goals have been met. The following Q&A addresses some of the primary issues to consider when structuring an earnout.

Q: Why should a seller enter into an earnout agreement?

A: There are many circumstances in which earnouts are useful for a seller, including:

- To resolve differences of opinion regarding the target companys projected earnings or other factors driving valuation.

- In the case of a turnaround because historical information may lack benefit to the purchaser in evaluating the price for the acquisition..

- To resolve differences in valuation resulting from analyses of economic matters or trends in the seller companys industry.

- Sellers who focus on software development and for service firms because the earnout can serve to induce management to make the transition and maximize profit.

- When the seller is committed to a valuation that seems unrealistic to the purchaser, establishing the earnouts benchmarks based on the sellers projections may appease the seller sufficiently to close the deal, while protecting the buyer.

Earnouts create an incentive for a seller to remain active in the business post-closing. The motivation is most effective when the seller has a finite period in which to achieve the earnout, a period that may coincide with the sellers plan to reduce his or her involvement in the business. An earnout typically would not be used where the seller retains a significant minority interest or a majority interest in the business and intends to benefit from a future sale or other liquidity event.

Q: How are earnouts typically structured?

A: Earnout terms should be as specific as possible and contain defined formulas. The use of hypothetical examples of the calculation of the earnout payment can provide guidance and clarity for the parties in the application of the formulas, minimizing the chance of disputes over computations and definitions.

There are several earnout structures, and they should be drafted carefully for each deal. A purchaser needs to carefully think through the terms. The purchaser wants to avoid an earnout that hamstrings its efforts to restructure the sellers business, or motivates the earnouts recipients to focus on short-term goals that may personally reward the seller, but may have adverse long-term consequences for the purchaser.

Most earnout periods conclude after a specified length of time generally between two and five years after closing. The appropriate term will be determined by how long it will take to measure the projected value of the target, or the period during which the purchaser desires to incentivize the former sellers.

Earnout payments can be based on a variety of measurable performance criteria. Such criteria involve EBIDTA (earnings before interest, depreciation, taxes and amortization), EBIT (earnings before interest and taxes), pre-tax net income, gross profit or sales. In addition, the earnout can be structured as a fixed or variable amount to be paid upon achievement of specified milestones, such as completion of specified projects.

When an aggregate earnout dollar amount is established, for the purchasers protection, payments of the earnout typically are made at a discount until the expiration date of the earnout. This cushions the purchasers risk of future financial target shortfalls, and the possibility that the seller will not make the purchaser whole for any overpayments when the final earnout payment is calculated. Conversely, as protection for the seller, the earnout would provide for a true-up between the annual earnout payments and the final payment at the end of the term. A seller, however, may seek the opportunity to make up any shortfall during the measurement period by averaging strong performances with weak performances. In that case, the purchaser may insist that any prior shortfall adjust payments due for the current year.

Q: Is EBITDA the best benchmark for employing earnouts? Why?

A: Parties often use EBITDA as an earnout milestone because the accounting treatment is well understood. EBITDA reflects the cost of goods and services, selling expenses and general and administrative expenses, and are recognized financial terms with established accounting principles, subject to adjustment based upon the parties negotiations. This measure also is desirable because it excludes interest, taxes, depreciation and amortization, which may vary based on the purchasers capital structure, or the way in which the acquisition is financed. For a transaction that is initially valued using a multiple of post-closing cash flow, the use of EBITDA for the earnout enables the seller to achieve what is in essence a deferred purchase price.

Regardless of the financial threshold chosen, the parties should carefully analyze the potential for the earnout to distort the incentive for producing long-term, sustainable growth for the purchaser. For example, using solely a revenue target may tempt the earnout recipients to book unprofitable sales. An earnout based on cash flow or income could incentivize the earnout recipient to slash expenses (e.g. marketing and advertising costs) to bolster short-term profitability at the expense of long-term growth.

Q: What are some of the most litigious aspects of earnouts?

A: There are several aspects of earnouts that give rise to disputes.

1. Determination of the earnout. The seller should insist that the purchaser maintain separate books and records for the target, division, or other source of the earnout throughout the earnout period. The purchaser should covenant that these financial records will be made available for review upon reasonable notice.

2. Accounting issues. For financial milestones, the parties should stipulate the precise accounting principles that will be used to calculate whether the thresholds have been met. Particular care in delineating the calculation principle should be used if the threshold is EBIT or EBITDA.

3. Consistency of practice and post-closing accounting. A problem may arise in the form of movement of revenue and expenses by the purchaser in control of the target after the closing. Due diligence into the pre-sale accounting policies of the seller will clarify past practice and reveal any areas of potential dispute.

4. Potential exclusions in calculating the payout and other possible adjustments. In using a net income, EBIT or EBITDA measure, the seller should seek to exclude all transaction and capital/financing expenses that are charged against the earnings upon which the earnout is calculated.

5. Uncertainty of Operational Procedures. The parties also may wish to include detailed post-closing operational procedures in the acquisition agreement in order to avoid uncertainty.

6. Sale of target by purchaser. The parties should determine whether the target or a portion thereof may be sold to a third party during the earnout period, and the effect of such a sale on the earnout should it take place.

7. Strategic Buyer or Rollup Platform. Strategic buyers often seek acquisitions to realize benefits from the consolidation of sales forces, manufacturing facilities, distribution systems and the like. A natural consequence of this consolidation may be to shift sales from the target to the purchaser, or vice versa.

8. Mismanagement during earnout period. Both the purchaser and seller may fear mismanagement during the earnout period that could affect the payout.

9. Multiple decision makers for seller. In situations in which the seller has several shareholders who are retained by the purchaser to manage the target, the parties should consider establishing a single person or committee as the representative to act on behalf of the persons who were shareholders of the seller at closing.

10. Target exceeds goals. The parties must decide whether performance well above threshold levels in one part of the earnout period may be applied to supplement a lesser performance during another part of the earnout period.

11. Targets are only partially achieved. An often difficult negotiation occurs about prorating earnout payments if the targets are only partially achieved. Sometimes this point is resolved by establishing a minimum hurdle that has to be achieved before any payment must be made and providing a sliding scale or proration after the threshold is achieved.

12. Dispute resolution. Disputes regarding earnouts are commonplace, and the lawyers drafting earnout provisions are advised to consider the appropriate form of dispute resolution under the circumstances.

Q: How much of an increase in earnouts have you seen post-credit crisis?

A: The economic downturn in 2008 and 2009 has caused more sellers to consider and accept earnouts. Sellers today may believe that their companies flat or declining performance will turn around quickly as the economy improves, yet purchasers are unwilling to pay for unproven performance. Also, the lack of senior debt acquisition financing, and the reticence of capital sources such as private equity groups to accept the sellers earnings multiplier, are driving sellers and their advisors to use earnouts to achieve the sellers price valuation while facilitating the purchaser to close the transaction with reduced up-front capital payments.