A tougher issue to tackle is defining the base. What standard will be used as the base — EBITDA, pre-tax net income, gross profit, sales or some other figure? Each of these standards has advantages and disadvantages for the parties. For example, a seller may prefer to use the sales method because he may feel that it is the only readily determinable, externally driven standard, while a purchaser might have concerns that sales could be driven up without regard to costs, thereby hurting profits. For example, sales would increase if a business added several salespeople and support staff, but the profits of the business could be hurt. A purchaser might prefer looking only to gross profit as a benchmark, but the seller may feel he has no control over how other company costs are accounted for.
Likewise, the agreement will dictate who is performing the calculations — the seller’s accountant or the buyer’s. This is important because results can vary if the standard is not meticulously defined. Typically, in buyouts we advise, the purchaser’s accountant performs the calculations, but the buyer’s financial team has the right to audit them. Earnouts can complicate the orderly transfer of the business. Usually a purchaser wants to change certain aspects of the business — so it can be effectively integrated into the purchaser’s business, for example. Conversely, a seller generally wants to maintain the business’s current operating processes and procedures, since they can make the computation of the earnout less complex. (There is also a natural tendency for the seller to be resistant to making changes in his or her business.) A wellcrafted earnout agreement will provide the seller with enough control of the business to make him feel it can qualify for the earnout payment, while providing the buyer with sufficient control to ensure that his acquisition will be well run during this period.
What Can Go Wrong
Problems arise when the earnout agreement is poorly drafted or the parties don’t fully understand the meaning and ramifications of the agreement. For example, disputes surrounding the calculation of the earnout base and subsequent earnout payments are not unusual. When a party doesn’t understand how a calculation should be made, expectations will be unfulfilled. Likewise, a seller who fails to retain sufficient control of the business during the earnout period is doomed to failure. If the agreement fails to provide the seller with such control and the buyer has the right to operate the business as he sees fit, the operation could conflict with the way the seller intended it to be during the earnout period. Or if the purchaser intends to integrate the business with his already established business, the seller may have a difficult time keeping his business’s results separate from the other’s.
It would seem as if a purchaser has less to lose from an earnout agreement than a seller. On the face of it, if the seller meets the earnout targets and qualifies for the additional payments, this would mean the business has exceeded the purchaser’s expectations — the value of the business is higher than he thought. However, just as a seller could have problems with the earnout agreement, so could the purchaser. If the buyer gives the seller too much control of the business during the earnout period, he runs the risk of having the seller undertake actions that could hurt the business’s performance in the future. The key is sorting out these questions before signing an agreement and having a clear delineation of what each party’s responsibilities and powers will be after the sale has taken place. Often agreements will provide that a board of directors can oversee conflicts or revise the listing of a seller’s duties with his or her consent.
An earnout can be a powerful tool that enables a business buyer and a business seller to find the common ground on which they can reach an agreement. But it’s critical that the earnout agreement be skillfully drafted and that both parties be well informed and cooperative. While earnout contracts typically provide for dispute resolution, such as mediation, that’s never a good ending to an earnout period. Whatever perspective you’re coming from in an earnout — whether you’re the buyer or the seller — everyone is better off avoiding that type of trouble.