The purchase price in a merger or acquisition deal is of paramount importance. Beyond the dollar amount, however, the manner of payment is critical as well. While most sellers wish to receive 100% of the purchase price in cash at closing, an earnout is a common component.
An earnout allows a seller to receive a portion of the overall purchase price after closing if the target company achieves certain performance goals.
Earnouts are often employed when a buyer and seller cannot agree on an overall value of a company. The earnout can bridge the divide in that it allows the seller to receive what they think their company is worth, if it performs as expected. Meanwhile, a buyer “hedges their bet” against overpaying for a company based on historical numbers and projections.
The COVID-19 pandemic has caused much performance uncertainty. Buyers and sellers may struggle to determine a company’s value and purchase price. To address these uncertainties, there likely will be an increase in earnouts.
Even without a pandemic, earnouts can be complicated. Three important considerations are:
- Metrics: The criteria used to determine if a seller has achieved the earnout. These are often, but not always, financial terms such as reaching certain EBITDA, revenue or new sales.
- Earnout length: Prior to COVID-19, the median length of an earnout period was around 24 months. As a result of current economic uncertainties, earnout periods will likely increase.
- Control: Since the earnout is often based on financial performance, a seller often wants a commitment from the buyer that the management team will be allowed to operate freely in order to achieve the earnout payment. This autonomy may not align with the buyer’s plans and will need to be negotiated by the parties.
It is recommended that sellers and buyers use experienced M&A negotiators as the complexity of determining purchase price and manner of payment increases.
Michael D. Makofsky is principal at McCarthy, Lebit, Crystal & Liffman Co., LPA.