COVID-19 is likely to increase the use of earn-outs in M&A transactions. Due to the unpredictability caused by the pandemic, buyers and sellers of companies have are less able to predict the earnings and future performance of the business. For parties structuring a transaction to deal with future uncertainties, earn-outs can bridge the valuation gap. An earn-out allocates the future risks and rewards of a business They are inherently difficult to design and implement because they require the parties to anticipate what might happen in the future.
The high stakes involved means that disputes can cause the expenditure of large amounts of time and money in litigation. A carefully designed and considered earn-out is worth the upfront effort if it can avoid or allow a dispute to be quickly resolved.
Before the pandemic, earn-outs were not generally used outside of deals in certain industries, generally those with high regulatory uncertainty. Some earn-out disputes happen because the earn-out structure was the wrong way to bridge the valuation gap.
For instance, earn-outs measured on EBITDA make more sense when the target business is operated stand-alone. It is easier to track whether the earnings have been achieved during the earn-out period when the business is compartmentalized.
If the operations of the target business will be integrated with those of the buyer, earn-outs based on earnings become difficult to manage and track because both revenues and expenses must be determined. When the acquired business operations are merged with the buyer, an earn-out based only on revenues may be more appropriate. Even then, if the products or services of the target company are combined with the products or services of the buyer, revenues specific to the sold business may be difficult to determine with objective certainty.
If the seller’s management team will not be working for the buyer, or have no real influence over the buyer’s operations and decision making after closing, the seller may not believe the buyer will be sufficiently motivated to achieve the earn-out. The seller may find it challenging to adequately monitor earnout progress without former management’s direct role in managing the business.
In many companies, founders and management may own a small equity stake in the target business. This means the management team may not have a sufficient interest in the earn-out to have an incentive to achieve it. Instead, the seller management team may have compensation incentives after closing that conflict with the earn-out.
These issues may lead to the conclusion that an earn-out is the wrong approach. If the buyer and seller have different expectations on whether and how an earn-out will be achieved, the result can be a costly dispute. This is particularly true if an earn-out is a significant portion of the purchase price. The seller must recognize the inherent risk in an earn-out. It can be difficult and expensive to challenge an unfavorable earn-out report even with seller-favorable earn-out terms.
What Is the Right Metric to Use for an Earnout? Deciding which earn-out metric is right starts with an analysis of how the buyer valued the business and whether that method is appropriate to measure the business during the earn-out period. Three common ways to value target companies are:
multiple of prior 12 months of EBITDA - used for companies with earnings;
multiple of revenues – usually used for companies that have been able to build significant sales but do not have earnings; and
“build versus buy”, where the buyer measures the cost to duplicate the seller’s product or technology, versus the cost to buy the seller.
The valuation method used to value the business starts the discussion for the earn-out metric. If a multiple of EBITDA was used to value the business, an increase in EBITDA is a logical place to begin. The same for revenues. When build versus buy was used, neither EBITDA nor revenue may fit the situation.
In any event, the choice of the earn-out metric requires a deep analysis of the value the buyer is trying to create by buying the target business, and its business plan to create this value after closing.
Generally speaking, revenue is the earn-out measure in most the cases. The rest are split into various factors. Of these, earnings are the second largest. Sellers generally prefer using revenue as a metric. Buyers favor using EBITDA because EBITDA is generally used to gauge a company’s true operating performance and to value a business for sale.
How to Define the Metric in the Agreement The answer is: (i) be as specific as possible, (ii) use objective measures that lend themselves to outside measurement by third parties, and (iii) use illustrative examples whenever possible.
For non-revenue/EBITDA metrics, the parties must be specific about each of (1) the milestone, (2) whether a milestone has been achieved, and (3) the deadlines for achieving each milestone.
Defining EBITDA can be complex. It is more common to define Adjusted EBITDA with specifications for how EBITDA is adjusted. The requires a review of each income statement line item of the target business to determine whether the line will be included in the EBITDA calculation for the earn-out. The analysis also requires thought about possible types of revenues or expenses that would be unfair to include in the calculation, like gains or losses from the sale of capital assets, gains or losses from a change in accounting policies, and gains or losses caused by one-time events outside of the ordinary course of business.
For example, if the target business has a loan under the Paycheck Protection Program, the parties will want to specify that forgiveness of the loan does not factor into EBITDA. A particularly difficult area is how shared expenses, like insurance or other overhead, will be allocated between the target and the rest of the buyer’s business.
It can be helpful to use a sample EBITDA calculation using prior financial statements showing how EBITDA will be calculated for the earnout calculation. It becomes more difficult if the acquired business will be integrated into a larger business and the accounting will change to conform to buyer’s accounting practices. In that case, it is helpful to create a sample template using the buyer’s accounting practices showing how EBITDA will be calculated.
For a financial metric like EBITDA, another issue is the proper accounting principles. If the target business has audited financial statements prepared in accordance with Generally Accepted Accounting Principles (GAAP), a typical definition of the Accounting Policies in a purchase agreement would be based on GAAP consistently applied.
Conflicts can come up when a target business is a relatively small business being bought by a larger company. Even if the target company has audited financial statements prepared in accordance with GAAP, there can be differing interpretations of GAAP and different policies. It helps if those differences in how GAAP is applied by each party are dealt with in the purchase agreement definitions of the applicable accounting policies and other financial terms used for the earn-out.
Smaller companies may not have GAAP-based financial statements. They may use the cash basis of accounting, the tax basis of accounting, or some hybrid. It is important to know how the target and buyer financial statements differ and how the earn-out metrics will be determined by the buyer. A template showing how EBITDA or any other metric will be calculated would help.
Structuring an Earn-out to Achieve the Right Result
Before the pandemic, parties generally wanted the earn-out period to be as short as possible. Now, with the unpredictability of how long it will take to recover from the pandemic, most companies have no visibility into what their results will be into 2021. Earn-out periods may extend into 2022, 2023, and beyond to give the seller more opportunity to achieve the earn-out. This puts more burden on the buyer to manage and track the earn-out through the longer timeframe. It also increases the risk that something unexpected will occur that affects the business and restricts the buyer’s ability to make changes that could potentially affect the earn-out, like merging the business with other buyer operations.
Due to the changed post- pandemic environment, the earn-out potential as a percentage of the closing payment may increase to 50% or higher. Buyers will shift more of the uncertainty and risk to sellers. As the size of the earn-out potential increases, there is more incentive for the seller to challenge the buyer over whether the earn-out has been achieved. This leads deciding whether the earn-out should be all or none or a sliding scale.
When all or nothing applies, it is frequently clear to both seller and buyer whether the metric was achieved. A disagreement becomes a formal dispute only when it will make the difference between all and nothing. A sliding scale may lead to more earn-out disputes. The disagreement may trigger a dispute at each stage if the disagreement is material.
An argument for using a sliding scale is that an all or none structure can demoralize the seller’s management team (now working for the buyer) if it becomes clear the earn-out will not happen. The sliding scale maintains an incentive. The sliding scale could reduce the amount subject to dispute.
When the earn-out potential becomes a larger portion of the total payment and the earn-out period is longer, the parties could divide the earn-out period into shorter intervals and provide for partial payments for each earn-out period.
Another issue with an increase in earn-outs is deciding what happens to the earn-out if the buyer is acquired during the earn-out period. Should the earn-out accelerate upon sale or continue in effect?
The size of the buyer relative to the size of the target business is a big factor in whether the earn-out should accelerate upon sale of the buyer. If the target business is a large portion of the buyer’s overall business, the sellers have a strong argument that the sale should trigger earn-out acceleration. On the other hand, if the buyer is substantially larger than the target business, the earn-out is less likely to contain acceleration on a sale. In any case, the purchase agreement should say what happens to the earn-out on a sale.
In the right circumstances, the parties might consider including a provision under which the buyer can pay a fixed sum, or use a different metric and time period to buy out and terminate the earn-out. This can be helpful if the buyer believes there is a reasonable possibility it could be sold during the earn-out period and would not want this to hold up the sale of the buyer.
Covenants for Operating the Target Business after Closing Buyers and sellers vigorously negotiate whether there should be constraints on how the buyer operates the business during the earn-out period. Buyers do not want constraints. They need full discretion to run the business to deal with rapidly changing business conditions. Sellers want a fair shot at being able to earn the earn-out, especially if the seller’s management team goes to work for the buyer.
Many times, unrecorded promises will be made to the seller for financial support or other resources that the buyer will provide to the business after closing so the earn-out can be achieved. They never make it into the purchase agreement and are generally unenforceable. This natural tension over the buyer’s business decisions will be worse if the earn-out period is long.
Sellers often push for a covenant that the buyer will operate the business in accordance with seller’s past practices. When sellers have a lot of leverage, they will ask for a covenant that the buyer will run the business to maximize earn-out payments. Although these types of covenants are sometimes made to get the deal done, they may cause problems. It may not be entirely clear what the parties mean by these covenants. The buyer and seller end up having very different interpretations of them. In a dispute, the seller must create a factual record of how the seller operated the business before closing and show how the buyer failed to do so during the earn-out period. More importantly, the seller must show exactly how that change affected the earn-out payment negatively and by how much.
If the earn-out period is long, buyers will be uncomfortable agreeing to any covenants that restrict their ability to run the business. Buyers will want a statement affirming the buyer has full discretion to direct the management, strategy and operations of the purchased business. If buyers have negotiating leverage, they may also want a statement expressly disclaiming any fiduciary duties to the seller on the earn-out. This is to avoid a claim that the buyer did not abide by any implied duty of good faith on the earn-out. Even if the purchase agreement is silent on fiduciary duties, some courts impose a high threshold for a seller to prevail on a claim based on an implied duty of good faith.
It is more common for buyers to agree to a negative covenant that the buyer will not take actions in bad faith that would reasonably be expected to materially reduce the earn-out. The parties will sometimes agree to an affirmative covenant for the buyer to operate the business in a commercially reasonable manner as a middle ground compromise. In a dispute this covenant is so vague that it will be difficult to make a claim without a specific definition or particularly bad facts. Gray areas created by ambiguous language like commercially reasonable manner will work to the buyer’s advantage because the buyer can provide an after-the-fact rationale to its actions. The more specific the definition, the more likely these issues can be avoided. For example, the parties can combine a general commercially reasonable efforts clause with a more specific operating covenant.
A covenant that could help minimize disputes is an obligation of the parties to negotiate in good faith if there is a material change in circumstances that may frustrate the earn-out. This obligation motivates the parties to work collaboratively to achieve the desired outcome for the buyer and secure at least a portion of the earn-out for the seller.
Determining Whether the Earn-out Metric Has Been Achieved Earn-out reporting requirements must be specific, precise, and provided to the seller on a regular basis. This is especially important if seller’s management is no longer working for the buyer. If former owners are working with the purchased business after the closing, the seller representative normally works closely with those former owners who act as its eyes and ears. Absent inside access and knowledge, it can be difficult to challenge an unfavorable earn-out report because the buyer controls the facts and the business records.
The purchase agreement should include broad rights to examine business records and interview seller’s employees now working for the buyer. These rights will allow the seller representative to examine an unfavorable earn-out report. The existence of these rights and the request to interview employees can create an incentive for the buyer to act appropriately.
The right to an audit is less important to sellers than one might think. Normally, disputes come from operating decisions made after closing that led to the unfavorable financial outcome; not actions by the buyer to unfavorably manipulate financial results.