By Jason J. Waldstein, Esq.        

Congratulations, you are a business owner who has built a successful business, and your business has caught the eye of a suitor. The suitor approaches you with an offer to buy your business, and the offer includes an upfront cash payment, plus future cash payments that the suitor calls an “earnout”.

Conversely, you are a business owner who is looking to expand its business with an acquisition, and you have identified the ideal target to acquire. You ask the target to present you with an offer to buy its business, and when it does so, the offer includes an upfront cash payment, plus future cash payments that the target calls an “earnout”.

You ask yourself, what is an “earnout”?

An “earnout” is a contractual mechanism in a merger or acquisition agreement, which provides for contingent additional payments from a buyer of a business to the seller thereof. Earnouts are typically “earned” if the business acquired meets certain financial or other milestones after the acquisition is closed.

Sounds simple, right? Unfortunately, earnout provisions are not simple and instead tend to be amongst the most hotly contested provisions in the course of the negotiation of a merger or acquisition agreement. 

There is not a typical or boilerplate earnout provision, but there are some basic considerations that factor into negotiating the earnout provision.

First, the milestones which, if reached, trigger payment of an earnout, need to be clearly set out in the agreement. Often, these are financial milestones, such as reaching a certain EBITDA, gross revenue or gross profit level during a prescribed period of time, but they can also be non-financial, such as procuring a certain number of customers or a regulatory approval within a predetermined time period.

Next, the parties need to specify how the milestones are measured. This includes determining whether there is a single earnout or multiple, staged earnout payments over time.

Then, and this is usually the consideration that is the most contentious, the control over the earnout business needs to be agreed upon. Sellers and buyers will likely have vastly different perspectives when it comes to this consideration. The buyer will often want maximum flexibility with respect to how it can operate the acquired business post-closing, especially as circumstances and the business environment changes. The seller, on the other hand, will often want to maximize its control over decision-making that can impact the earnout. The seller also usually asks the buyer for commitments to fund the earnout business properly or consistent with past practice, and even to take steps intended to maximize the ability to achieve the earnout benchmarks.

When it comes to this consideration, the buyer will ask the seller to agree to various obligations and covenants of the buyer to protect the possibility that the earnout will be paid and maximized. The seller will, at the very least, ask for an obligation of the buyer to operate the acquired business in good faith and to deal with it fairly. The seller will often ask for a requirement that the buyer not take affirmative actions (or omit to take action) for the purpose of preventing or reducing the earnout payments. The seller will often ask for an obligation of the buyer to use commercially reasonable efforts to operate the acquired business in a manner that will maximize the earnout payment. The seller may ask for an agreement that the buyer will provide ongoing financial and other support to the acquired business. To these asks, the buyer will likely resist and ask that its obligation be subject to only using “commercially reasonable efforts.”

An “earnout” is not used in every merger or acquisition, but when it is used, it is usually an important component, one in which the devil is truly in the details.

For more information, contact Jason J. Waldstein at jjw@spsk.com or at (973) 540-7319.