EARNOUT in a Business Sale Transaction

Contact Neufeld Legal PC for corporate transactional and legal matters at 403-400-4092 / 905-616-8864 or Chris@NeufeldLegal.com

An earnout is a contractual provision in a business sale where a portion of the purchase price is contingent on the acquired company's future performance. Instead of paying the full price upfront, the buyer pays an initial amount at closing and agrees to make additional payments to the seller if the business achieves certain predetermined financial or operational targets over a specified period.

The specifics of an earnout are heavily negotiated and detailed in the purchase agreement, with the key components including:

• Valuation Gap: Earnouts are most commonly used to bridge a valuation gap between the buyer and seller. The seller may have a more optimistic view of the company's future growth, while the buyer wants to mitigate the risk of overpaying for that potential.

• Performance Metrics: The earnout payment is tied to specific, measurable metrics. These are most often financial, such as:

  • Revenue: A straightforward metric that's difficult to manipulate.

  • EBITDA: Earnings Before Interest, Taxes, Depreciation, and Amortization. A more comprehensive measure of profitability.

  • Net Income: The "bottom line," which can be more easily affected by a buyer's post-acquisition decisions.

  • Non-financial metrics are also used, particularly for early-stage or high-growth companies, such as achieving a regulatory approval, launching a new product, or securing a certain number of new customers.

• Earnout Period: This is the timeframe over which the performance is measured, typically ranging from one to five years. The payments can be made in a lump sum at the end of the period or in installments as targets are met.

• Calculations: The agreement must explicitly define how the metrics will be calculated, including what costs or revenues are included or excluded. This is a critical point of negotiation to prevent disputes later on.

Risks and Considerations with Earnouts in Business Sale Transactions

From the Perspective of the Seller of the Business:

• Lack of Control and "Buyer's Remorse": Once the deal closes, the buyer is in control of the acquired business. The seller, even if they stay on in a management role, loses the ability to make key decisions. The buyer's business decisions (e.g., changes in strategy, integration with other businesses, or cost-cutting measures) can negatively impact the company's performance and, consequently, the earnout payment. This is a major source of disputes.

• Ambiguous Terms: Vague or poorly drafted earnout provisions are a leading cause of disputes. Issues can arise from how performance metrics are defined, calculated, and measured. For example, is "revenue" gross or net? Is "EBITDA" calculated before or after certain expenses?

• Manipulation by the Buyer: A buyer may intentionally or unintentionally take actions that minimize the earnout payment. This could include shifting revenue or expenses to or from the acquired business, overspending on R&D or marketing, or paying excessive "insider" salaries.

• Difficult to Litigate: Earnout disputes are notoriously difficult and expensive to litigate, as they often involve complex accounting issues and the implied covenant of good faith and fair dealing.

• Conflict of Interest: If the seller is also a member of the post-acquisition management team, their financial interests in maximizing the earnout can conflict with their fiduciary duties to the new company.

From the Perspective of the Buyer of the Business:

• Ongoing Relationship with the Seller: The earnout structure creates a lingering relationship with the seller, which can be a source of tension and ill will, particularly if targets are not met.

• Operational Constraints: The earnout agreement may place restrictions on the buyer's ability to fully integrate, restructure, or operate the newly acquired business. For example, the buyer may be required to maintain a certain level of investment in the acquired company, even if their broader business strategy dictates otherwise.

• Seller's Potential for Manipulation: Sellers who remain involved may engage in short-term tactics to meet earnout targets, even if those actions are detrimental to the long-term health of the business (e.g., pulling future sales into the earnout period).

• Complexity and Administration: Earnout agreements are complex and require meticulous drafting. They also necessitate a system for tracking and reporting on the performance metrics, which can be an administrative burden.

• Financial Uncertainty: The buyer's final purchase price is not known until the earnout period concludes, which can create financial unpredictability for the buyer.

When it comes to the legal component of corporate mergers & acquisitions, that is when the law firm of Neufeld Legal P.C. comes into play. Such that when your company is seeking knowledgeable and experienced legal representation in orchestrating and completing business mergers, acquisitions and divestitures, contact us at strong>403-400-4092 [Alberta], 905-616-8864 [Ontario] or Chris@NeufeldLegal.com.