Earnouts 1. Overview a.

An earnout provision makes a portion of the payment to the sellers contingent upon the target reaching specified milestones during a specified period after the closing. The milestones used are usually financial, such as net revenues, EBIT, EBITDA, net income or earnings per share. b. Earnouts are most often used when the buyer and sellers cannot agree on the value of the target. They are particularly useful in volatile industries or when the buyers projections for the target are more pessimistic than the targets. An earnout arrangement rewards the sellers if their projections are accurate, while protecting the buyer from overpaying if they are not. c. In situations in which the targets management/shareholders will continue to manage the target after the closing, an earnout arrangement may be used by the buyer to motivate management. If the earnout used in this context is characterized as compensation rather than payment for the business, there will be an immediate hit to the buyers profit and loss statement rather than being treated as goodwill or

some other type of property that can be amortized over the life of the asset. 2. Some risks associated with the use of earnout provisions a. Earnouts have great potential for engendering later dispute about the contingent payment. Disputes often arise when the sellers suspect that the buyer is using different accounting techniques during the earnout period to diminish the payout, or is artificially depressing revenues or earnings during the earnout period. b. The sellers may fear that the buyer will not run the business successfully. c. Buyer faces the risk that the payout formula will overcompensate the sellers due to other acquisitions or a change in the buyers postacquisition business plan that has little to do with the target. d. Earnouts tend to limit the ability of a buyer to integrate the targets business into the buyers other business. e. Buyers can use earnouts as a source from which they can offset indemnification claims.

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Negotiation issues a. Setting the earnout milestones

Earnout milestones may be financial or nonfinancial in nature, or a combination of each. In choosing milestones, and in negotiating the agreement, the parties should identify and deal with any post-closing contingencies that could potentially alter the targets ability to meet the earnout milestones. (a) Financial milestones Common financial milestones include the targets net revenues; gross margin; net income; cash flow; earnings before interest and taxes or EBIT; earnings before interest, taxes, depreciation and amortization or EBITDA; earnings per share; and net equity thresholds. Revenue-based milestones are often more attractive to sellers because they will not be affected by operating expenses. The buyers post-closing accounting practices and business decisions will likely have less impact on revenues than other items.

 A buyer may be reluctant to use revenues as the milestone if the sellers continue to run the business because a revenue test does not encourage the sellers to control costs. Buyers generally favor net income thresholds on the grounds that they are the best indicator of the targets success. Parties often use EBIT or EBITDA measures as milestones in order to reduce concerns about revenues and net income measures. EBIT and EBITDA reflect the cost of goods and services, selling expenses and general and administrative expenses, and are more difficult to manipulate. They exclude interest, taxes, depreciation and amortization, which may change because of an acquisition. (b) Non-Financial Milestones. Non-financial milestones are often used in acquisitions of development-stage companies. These companies may be difficult to value, due in part to their high growth rates, and are particularly suited to the use of non-financial milestones. Non-financial milestones may also serve the purpose of giving operational focus to the target. b. The formula for calculating the payment amount

For financial milestones, the parties may stipulate a flat amount to be paid if the milestones are met. More typically, the buyer will pay the sellers a specified percentage of the amount by which the targets performance surpasses each milestone. For nonfinancial milestones, the parties must agree upon an amount of cash consideration or a number of shares of stock that will be delivered for each milestone that is met. The payout is often capped at a specified amount. c. The length of the earnout period

Most earnout periods conclude within two to five years after the closing. The nature of the milestones used will help determine the length of the earnout period. d. Determination of whether the milestones have been reached (a) The buyer and its accountants will typically make the initial determination of whether the milestones have been reached. The sellers will then review the calculations and challenge them if appropriate. In some situations, it may be appropriate to require that the results of the earnout period be audited. (b) The sellers should insist that the buyer maintain separate books and records for the target
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throughout the earnout period which will be made available for review upon reasonable notice. e. Operation of the acquired business during the earnout period Both the buyer and the sellers may fear mismanagement by the other party during the earnout period, which could affect the payout. (a) Operation by the buyer post-closing Usually the buyer will control and manage the business of the target after closing. In situations in which the targets management team will not be retained post-closing, the sellers will likely require that the buyer operate the target in the ordinary course of business consistent with past practice, and will attempt to reserve, through contractual covenants, some authority regarding major decisions made during the earnout period. (b) Operation by the sellers management team post-closing Sometimes the targets management will continue to manage the business post-closing. In this situation, the buyer faces the risk that the targets management team will operate the business so as to inflate the payout.
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(c) Protections placed in the agreement The parties may also wish to detail operational specifics in the acquisition agreement in order to avoid uncertainty. For example, the buyer might agree to restrictive covenants that prevent the target from taking specified actions during the earnout period. The seller may require that the buyer adequately fund the target during the earnout so it will be able to capitalize on opportunities presented to it. f. Accounting issues

For financial milestones, the parties should stipulate the accounting principles that will be used to calculate whether the milestones have been reached. A reference to GAAP does not provide adequate guidance. The parties may wish to incorporate into the agreement a list of accounting principles to be employed. Common accounting problems that may arise: (a) Consistency of practice in post-closing accounting Problems may arise from movement of revenues and expenses by the party in control of the target after closing. The parties should address this possibility and stipulate that post-closing
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accounting in this regard should not vary from prior practice. This will be difficult if the target is significantly different in the hands of the sellers from the way it will be in the hands of the buyer. (b) Potential exclusions in calculating the payout and other possible adjustments When net income is used as the performance yardstick, the parties nearly always add back goodwill amortization connected with the transaction or adjust for increased interest expense or higher depreciation caused by a writeup in assets in the acquisition. When net income, EBIT or EBITDA are used as the performance measures, the sellers should identify what administrative or general overhead expenses the buyer will allocate to the target after closing and determine how those expenses will impact the post-closing figures. The sellers will also argue that indebtedness resulting from the acquisition and non-target executive compensation expenses and management fees allocated to the target after closing should be excluded when calculating the payout. The parties will normally exclude extraordinary gains and losses.
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(c) Payments pursuant to tax-sharing agreements In some situations the target, once acquired, will become a member of the buyers consolidated taxpayer group. The sellers should assure that tax payments made by the target to its new parent company do not have unanticipated effects on the earnout. (d) Accounting treatment of the contingent consideration when linked with future employment A difficult accounting issue arises in those transactions in which contingent consideration is linked with the continued employment of the targets management. In transactions in which the contingency is based on the future earnings of the target and the management of the target enters into employment contracts with the new entity, the additional payments may be characterized as compensation expense. The FASBs Emerging Issues Task Force reached a consensus on this issue in EITF 95-8, Accounting for Contingent Consideration Paid to the Shareholders of an Acquired Enterprise in a Purchased Business Combination. EITF 95-8 notes that the following factors should be
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considered when evaluating the accounting for contingent consideration: reasons for contingent payment provisions; the formula for determining contingent consideration; linkage of payment of contingent consideration with continued employment; and composition of the shareholder group.

The determination as to whether payment of contingent consideration represents purchase price or compensation is based on facts and circumstances. EITF 95-8 notes that if a contingent payment arrangement is automatically forfeited if employment terminates, a strong indicator exists that the arrangement is, in substance, compensation. EITF 95-8 goes on to note, however, that the absence of linkage between continued employment and payment of contingent consideration does not necessarily imply that the payment of a contingency represents purchase price.

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g.

Form of payment of earnout obligation

Cash is normally used as the earnout payment, but the contingent consideration could be stock or notes. The use of buyer stock raises various valuation, securities and tax issues. h. Sale of the target during the earnout period

The parties should determine whether the target or a portion of the target may be sold to a third party during the earnout period, and the effect of such a sale. A similar problem arises when a third party acquires the buyer during the earnout period. The sellers may suggest that the third party buyer be obligated to pay off some or all of the earnout amount at the time of the second sale. i. Integration of the target into the buyers other businesses The parties must decide how to calculate the earnout when the target will be merged into other entities owned by the buyer. The difficulty of measuring performance in this case may make a buyer reluctant to fully integrate the acquired business into the rest of the buyers company. A similar problem arises when the buyer acquires other similar businesses during the earnout period. In these situations, the buyer and sellers must formulate a plan for segregating the financials that form the basis of the targets earnout
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milestones. This segregation can preclude the buyer from achieving the economies of scale and other synergies it anticipated in the acquisition. j. Averaging periods of strong performance with weak performance The parties must decide whether strong performance in one part of the earnout period may be applied to supplement poor performance during another part of the earnout period. k. Dispute resolution

Disputes regarding earnouts are commonplace. Many earnouts require binding arbitration of disagreements that the parties cannot resolve within a brief period of time.

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