Pitfalls for the Unwary Seller
Overview
In private M&A transactions, earnouts provide sellers with an opportunity to receive one or more post-closing payments upon the achievement of certain financial targets and/or operational milestones, helping to bridge the gap when the buyer and seller cannot agree on the value of the target business. In recent years, with high-interest rates, reduced access to debt financing, and concerns about future growth opportunities, earnouts have helped parties get deals to the finish line.
Despite their utility, earnouts must be carefully negotiated and drafted to reduce the likelihood of future disputes and thwarted expectations, particularly in cases tied to bottom-line results, complex calculations, and/or when the target company is being integrated into the buyer’s other businesses.
While this article focuses on certain pitfalls of earnouts from the seller’s perspective, the issues it raises are instructive for buyers as well.
Calculation Methodology
While the future satisfaction of EBITDA (i.e. earnings before interest, taxes, depreciation, and amortization) or revenue targets are often used to determine the amount of the contingent payments, buyers and sellers may use a variety of metrics (such as customer retention or growth), depending on the nature of the business and the parties’ particular concerns.
With financial targets, sellers should push for revenue rather than a profitability standard, as costs and expenses are more subject to buyer manipulation post-closing. However, buyers often require an EBITDA metric to be used, in which case the seller must ensure an objective and appropriate accounting method is chosen on which to base the calculations. The method for calculating EBITDA with respect to the earnout should be (1) clearly defined in the purchase agreement, (2) detailed, and (3) applied consistently with the seller’s historical accounting practices. When the seller’s business is being integrated into the buyer’s, it’s also important that the buyer be required to treat the seller’s business as a separate entity for accounting purposes and maintain separate books and records throughout the earnout period.
The seller should also identify business contextualized contingencies to be included or excluded from the calculation. If the seller’s business is being integrated into a larger business unit of the buyer, the seller should precisely identify expected post-closing items of income (such as revenue from common customers) or expenses (such as office rents) that will be shared and provide for appropriate allocation requirements. Certain items may be eliminated from the calculation of EBITDA, such as intercompany fees and one-time extraordinary expenses.
Post-Closing Operation of the Business
Whether or not the selling owner is involved in the post-closing operation of the target’s business, the seller will be vulnerable to the buyer’s decisions following the sale, which could negatively impact the metrics underpinning earnout calculations. Under Delaware law, absent express contractual provisions, a buyer generally has a good faith obligation not to take actions for the purpose of frustrating an earnout, but it has no obligation to use its best or reasonable efforts to maximize it. The burden of proof falls on the seller to show actions by the buyer were not in accordance with this standard, and when a buyer can point to any countervailing business concerns for decisions other than an intent to minimize the earnout, courts are reluctant to hold the buyer responsible for failure to attain the performance metrics. In effect, without specific contractual provisions relating to the buyer’s post-closing conduct of the business, a seller will have a high bar for succeeding on an earnout claim.
In the purchase agreement, the seller can protect itself more effectively by negotiating for specific and clear rights and covenants that are tailored to the business and impact the earnout. For example:
- A covenant requiring the buyer to operate the target business consistently with the seller’s past practice may be helpful, but as a general standard, it requires a fact-intensive analysis. To potentially minimize uncertainty about how courts will interpret an action, the seller should consider more specific covenants. A more seller-friendly general covenant would prohibit the buyer from taking any action that would reasonably be expected to have a material adverse effect on EBITDA; however, in practice, buyers often do not agree to this.
- Specific covenants during the earnout period might include not diverting customers to other business units of the buyer, spending a minimum amount on sales or marketing efforts, maintaining a minimum amount of working capital relating to the seller’s business, and restrictions on the disposal of assets.
- If possible and applicable to the deal, the buyer may be required to allow for key personnel of the seller to maintain operating control of the target business or the seller may be given consent rights for certain major actions, like incurring large debts or hiring or firing key employees.
- The seller may be able to provide for an accelerated payment of the maximum earnout (or some portion of it) upon a change of control of the buyer or sale of the seller’s business unit during the earnout period.
Other Earnout Considerations for the Seller
Tax Implications. Sellers need to be aware that the drafting of the earnout provisions and the facts and circumstances of the situation will determine whether earnout payments are treated as deferred purchase price (with capital gains treatment) or compensation for services (taxed as ordinary income). If the seller is providing employment or contractor services to the buyer or the target business post-closing, the seller should try to include specific contractual provisions that the earnout is considered additional purchase price consideration and will be treated as such for tax purposes by both parties.
Security for Earnout Payments. If the seller has enough negotiating power, it should add some security for the buyer’s future payment of the earnout, which could include an escrow or a parent guaranty.
Dispute Resolution. With respect to the calculation of earnout payments, the seller should be sure to include clear and detailed dispute mechanisms, including the right to receive and review detailed statements regarding the buyer’s calculations and the referral of any disputes to an independent accountant. In the event the buyer breaches its post-closing covenants for operating the target business, the seller will often be in better shape if it has a right to liquidated damages (which may be payment of the maximum earnout amount), as actual damages may be difficult for a court to calculate.
Riggs Davie Deal Team Note
If you have additional questions, please reach out to the mergers and acquisitions practice group at Riggs Davie PLC. We counsel clients through deals on the buy-side and sell-side in a wide range of industries, including technology, health care, HealthTech, FinTech, professional services, financial services, real estate, business services, manufacturing, and distribution. For more information about our services, please visit www.riggsdavie.com or contact our practice group by email at dealteam@riggsdavie.com.
