Buyers love earnouts because they don’t have to pay unless Seller performs and they usually get to decide whether Seller has performed or not. Sellers sometime like earnouts as well because, at least on paper, they give the illusion of a bigger size deal.The fundamental problem with earnouts is that the Seller is being judged on the performance of a business that he or she no longer owns or controls. Unless the Buyer leaves the acquired business completely autonomous, with the same leadership, same personnel and infrastructure, and same allocation of resources, it is very hard for Seller to make an apples to apples comparison.
Seller is going to be dependent on the goodwill of Buyer to provide adequate capital, resources, leadership and mission support to the acquired business. If Buyer neglects the new business, cannibalizes its leadership or resources, or changes its product lines or business, Seller is not going to achieve the earn-out no matter what he or she does. I represented a software company Seller a few years back in a sale where, without warning us, Buyer shut down Seller’s product lines immediately after the closing with a view to moving Seller’s customers to its own product lines. (The strategy ultimately failed and Buyer was forced to revive the acquired business). Then, after shutting down Seller’s business, Buyer declined to pay any earn-out on the theory that the business was shut down. Fortunately, we specifically drafted against this contingency and ultimately prevailed in arbitration, recovering almost the entire earnout.
The key takeaway is that, if the Seller has bargaining power (the real ability to walk away from the deal), the right play is to push for detail in the deal documents. Flesh out exactly who is going to make decisions, what resources and personnel are going to be made available, and how much capital will be provided to the business. And make sure that the metrics that are going to be used to judge the earn-out performance track the methodologies that Seller historically used to account for its business so that there is a fair apples to apples comparison.
On the other hand, if Seller is a stressed seller (he or she has to do the deal), then pushing for a lot of detail doesn’t make a lot of sense. The more detail is fleshed out, the worse off Seller is going to be because Seller doesn’t have any bargaining power. In that case, ambiguity isSeller’s friend. Because while ambiguity is not going to yield a clean result, it will assure that Seller has at least a seat at the table to negotiate when the earnout period expires.
When I represent a stressed Seller, I usually push the drafting of the earn-out to Buyer’s counsel. Earnout provisions tend to be very complex because of the accounting methodologies, so the first drafts tend to be half-baked, with lots of omissions and ambiguities. But rather than try to flesh those out, I will then largely accept the incompletemethodology. Seller is happy. He does not have to pay more legal fees. But what I have effectively done is deferred the hard bargaining from now, when my client has no leverage, until later when the earn-out period is over when my client will have a lot more leverage to negotiate.