Earnouts are a common element of a creative deal structure, especially where there is a value gap between the buyers best offer and the sellers valuation expectation. During the economic downturn we have experienced over the last 18 months, structured transactions including earnouts have become more common.
Negotiators looking to craft earnouts that are fair and agreeable should consider:
- Terms that can be clearly defined and measurable by both parties: Earnouts based on revenue or earnings can be strictly defined in accounting terms; deals based on achieving a specific level of employee or customer satisfaction can be more problematic to quantify.
- The sellers control of resources that impact achieving the earnouts success: Negotiations will also focus on the buyers desire to integrate business operations.
- An achievable earnout: Hurdles set too high could create disincentives and result in poor performance.
- Reasonable limits on the earnout that preclude a windfall that enriches the seller in a way that removes incentives going forward.
- Allowance for the later revision of terms in the event there is an unusual or catastrophic event that makes reaching earlier objectives unachievable. To address this issue, some multi-year earnouts allow any shortfall to roll from one year to the next, offering the seller a second chance to meet the target.
- Limits on corporate expense allocations that could negatively impact the earnout: Without such limits, earnings-based earnouts may not work.
The term of the earnout should be long enough to eliminate the impact of short term business swings, so a year is the minimum period recommended. Earnouts over longer periods allow the expense of the payout to be spread over a larger revenue or earnings base, thereby allowing for a larger potential payout.