Tanner Montague came to town from Seattle having never owned his own music venue before. He’s a musician himself, so he has a pretty good sense of good music, but he also wandered into a crowded music scene filled with concert venues large and small.But the owner of Green Room thinks he found a void in the market. It’s lacking, he says, in places serving between 200 and 500 people, a sweet spot he thinks could be a draw for both some national acts not quite big enough yet for arena gigs and local acts looking for a launching pad.“I felt that size would do well in the city to offer more options,” he says. “My goal was to A, bring another option for national acts but then, B, have a great spot for local bands to start.”Right or wrong, something seems to be working, he says. He’s got a full calendar of concerts booked out several months. How did he, as a newcomer to the market in an industry filled with competition, get the attention of the local concertgoer?
Earnouts, a form of contingent payment payable upon completion of a post-closing financial and/or performance-based milestone, are a relatively common feature in business transactions and their usage is becoming more widespread.
The circumstances under which earnouts are utilized vary from transaction-to-transaction. In some cases, an earnout is used to bridge a valuation gap; for example, if the buyer and seller are unable to agree upon a valuation of the target and thus a fixed purchase price.
This may be the case if the target is operating a new business line, and a historical basis for the valuation is lacking, or if economic trends and market conditions are particularly uncertain, and buyers are being conservative in offering prices. Additionally, earnouts may be used if an employee or group of employees is crucial for the target’s success.
In the SRS Acquiom 2023 M&A study of deal terms, the financial transaction manager analyzed more than 400 private-target M&A transactions that closed in 2022 and found that 21 percent (excluding life sciences transactions) contained an earnout. In 85 percent of the transactions, the earnout period was three years or less.
Earnouts are not without risk, particularly to sellers. One such risk is post-closing disputes between buyer and seller, which often center around the calculation of the metric(s) driving the earnout payment. Furthermore, following closing, buyer and seller are still relatively unfamiliar with the other’s management style. A seller may thus be skeptical as to how its business will be managed by buyer after closing, including whether it will be managed in a way that might reduce the likelihood of the earnout being achieved.
With all of this in mind, how might a seller approach the negotiation of an earnout? Matters for sellers to consider include:
Type and reasonableness of milestones. Financial-based milestones are more common than performance-based milestones. Of the different types of financial-based milestones, revenue, net income and EBITDA are the most widely used.
While net income links the earnout to profitability, it poses greater risks to a seller because the buyer is more easily able to control and/or manipulate the treatment of interest, taxes, depreciation and amortization in its calculations. For that reason, sellers frequently prefer EBITDA milestones. Whatever milestone(s) is utilized, it should not be so aggressive as to be entirely unachievable. Buyers may be overly ambitious in proposing milestones to reduce the likelihood of them being attained.
Length and termination of earnout. An earnout should be of limited duration. As noted, current trends reflect earnout periods of three years or less. Generally, the longer the earnout period, the greater the risks. There are metrics other than time, however, such as the occurrence of a specific event, an option by buyer, and/or a sale of the target, that may trigger and/or terminate an earnout.
Of these metrics, the ability of buyer to terminate an earnout in exchange for a predetermined payment is generally least preferred by sellers because such payment is generally lower than what might otherwise be achievable.
Accounting matters. Seller should ensure that the same accounting treatment (i.e., methods, policies, principles, practices, and procedures) is applied in calculating the milestone(s) following closing as what seller applied prior to closing. Frequently, this is U.S. generally accepted accounting principles or the methodology utilized in preparing seller’s financial statements. This treatment should be described in the definitive agreement, together with any items seller believes warrant unique treatment and/or exclusion from any calculation (i.e., overhead allocations and intercompany fees such as management, general and administrative, and accounting) in order to maintain consistent treatment.
Post-closing operations. A seller may seek to define parameters as to how the target must be operated after closing. For example, seller might provide that the target be operated as an independent subsidiary of buyer, subject to the reasonable direction of a board of directors of which certain seller representatives are members.
Additionally, seller might provide that key executives of seller continue in their roles, with the authority to operate target with financial resources that will allow it an opportunity to grow. To the extent there are intercompany transactions, a provision that pricing for such transactions is on an arm’s-length basis may be considered.
These are provisions, however, on which it may be challenging for a seller to prevail. Alternatives may include requiring the target to be operated on a reasonable basis post-closing to achieve the earnout or that buyer operate the target after closing in accordance with seller’s past practices.
Dispute mechanism. Because of the risks associated with earnouts, a mechanism for resolving disputes between the parties is essential. Such dispute resolution procedures frequently mirror those set forth in the purchase agreement with respect to purchase price (i.e., working capital) adjustments. Seller should be given a reasonable period, such as 30 to 45 days, in which to review buyer’s calculation of the earnout and be granted reasonable access to the target’s books and records during this time.
Seller will want an opportunity to submit an objection notice to buyer with respect to any item(s) of the earnout calculation disputed by seller.
After a good faith negotiation period between buyer and seller, any remaining disputed item(s) should be submitted to an independent accountant for resolution. Frequently, the fees and expenses of such independent accountant are borne by buyer and seller in such proportion as their respective calculations of the earnout differ from that as finally determined by the independent accountant.
The foregoing is merely an overview of certain attributes of earnouts and considerations for sellers with respect thereto. Earnouts can be extremely complicated and fraught with nuances.
Thus, if you find yourself privy to a transaction in which an earnout is being contemplated, involve your attorney and accountant as early as possible in the process. They can assist you in negotiating and structuring the earnout to better increase the likelihood it’s realized.
