Resolving Valuation Deadlocks in M&A: The Strategic Role of Earnouts

Valuation disagreements between buyers and sellers can sometimes prevent an otherwise promising business acquisition from closing. Earnouts have become a common tool in bridging this valuation gap by tying part of the purchase price to the future performance of the acquired company. In this article we explore the concept of earnouts, offering insights into their advantages, potential pitfalls, and strategic applications.

What are Earnouts?

An earnout is a contractual provision in a merger or acquisition (M&A) agreement, designed to facilitate additional contingent payments from the buyer to the seller’s shareholders post-transaction. These payments are triggered only if the acquired company meets certain pre-agreed financial targets or milestones following the deal's closure. This mechanism serves to mitigate the buyer's risk of overpaying while allowing sellers to secure a valuation that reflects the potential growth of their business. Earnouts are “success based” portions of the purchase price which are paid after the sale closes, often between 1-3 years after the closing date and typically no more than 10-20% of the purchase price.

Earnouts are different from deferred purchase price payments, such as a seller note, or an indemnity holdback or escrow amount, where purchase price is withheld to cover potential liabilities and then released once a certain amount of time has passed without claims. Earnouts are also different from an equity rollover where the selling shareholder received equity in the buyer equal to a portion of the purchase price, thus giving the seller a second bite at the apple when the buyer is itself acquired by an even bigger company down the road. Although these deferred payments or equity rollover are also part of the purchase price (similar to earnouts) and payment is delayed for years after the closing (also similar to earnouts), they are not linked to performance metrics. Earnouts are not guaranteed payments, but rather are contingent on some type of positive performance post-closing, such as hitting minimum future earnings.

Advantages of Earnout Agreements

Earnouts are especially beneficial in scenarios where the target company’s future performance is unpredictable, a common situation in industries grappling with rapid technological or regulatory changes. When the owner is predicting improved performance in the year or two following the sale, earnouts can be used to reward that performance if the seller’s forecast turns out to be accurate. This contingent earnout structure can persuade a seller to sell now, rather than wait, while also protecting the buyer from overpaying for a business that fails to perform as expected. Earnouts mitigate risk for buyers and help improve pricing for sellers. Earnouts are most useful when a selling owner-operator will remain involved in operating and growing the business during the earnout period.

Potential Pitfalls

While earnouts can align interests and help bridge gaps in pricing between buyer and seller, they can also create a fertile ground for potential disagreements over whether they were earned and, if not earned, who was at fault. Areas of potential disagreement regarding whether an earnout was earned or should be paid include:

  1. Ambiguous performance targets or differing interpretations of financial targets or operational milestones can lead to disputes over whether the earnout has been achieved.
  2. Co-mingling and integration of the two businesses can make it difficult to allocate financial results between the two businesses to determine whether the seller’s business achieved the earnout.
  3. The buyer will own the acquired business and will have managerial control over how it is run, who is hired, who is fired, and whether it will continue to be run consistent with past practice. These management decisions during the earnout period can be a source for litigation when the earnout is missed and the seller blames buyer for poor management decision making.
  4. Related to management decisions are capital and financing decisions. The buyer may starve the business of growth capital in order to focus on growing (or saving) its other business segments, thus financially holding back growth of the acquired business towards meeting the earnout targets.

Other Considerations

Avoiding earnouts simplifies the transaction and provides a clearly defined transition date at closing. This gives the buyer flexibility to integrate the business fully without delay and operate it as desired without concern for how that may impact earnout performance metrics and co-mingling concerns, and gives the seller a clean break, particularly when they will not remain with the business after the closing. When earnouts are unavoidable, or are used to incentivize an owner-operator’s continued attention to the business, they can be helpful to align the parties goals toward success. Earnouts require diligent management to ensure they fulfill their intended purpose. Without careful oversight, there's a risk that earnouts could lead to unintended side effects, such as neglecting areas of the business not directly tied to the earnout criteria, potentially harming the company's long-term health.

Paving the way for Successful Acquisitions

As highlighted throughout this article, earnouts can be an effective strategy in M&A deal-making, providing a strategic resolution to valuation impasses and ensuring that buyers and sellers are vested in the joint success of the business. The efficacy of earnouts hinges on meticulous negotiation and an in-depth appreciation of their potential risks and rewards. Recognized as "The Lawyers Who Close Deals," Adams Corporate Law has a proven track record of turning complex M&A challenges into advantageous outcomes. Our expertise in crafting and executing earnout agreements can set the stage for sustained business growth and collaboration, a successful closing, and ultimately a successful transaction which is a win-win for both buyer and seller.

To discuss how Adams Corporate Law can customize earnout strategies for your business and help seal your next deal with confidence, contact us at (714) 619-9360 or visit us online to learn more at adamscorporatelaw.com.


* It should be noted that the above scenario is intended as an example only and should not be regarded or relied upon as advice to any specific client or regarding any specific situation.

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