Home > Insights > Publications > How to use earnouts in M&A transactions during COVID-19

How to use earnouts in M&A transactions during COVID-19

Greg Mennerick Brent Trame Michael Rosenblum June 29, 2020

The COVID-19 pandemic has caused a valuation gap between buyers and sellers in certain industries. As a result, we expect parties to increasingly turn to earnouts, a form of contingent purchase price consideration, to help close transactions.

Buyers, sellers and M&A practitioners must carefully consider the complexity of earnout terms to create the optimal structure, align the parties’ incentives and avoid future disputes. Below are a few key considerations to keep in mind when drafting and negotiating earnout provisions.

1. Earnouts can bridge the valuation gap

An earnout is a post-closing purchase price payment that is contingent on the acquired business satisfying negotiated performance goals after closing. Earnouts can be a useful tool for buyers and sellers with different views on the value of the business, allowing them to avoid difficult purchase price negotiations. With the pandemic causing significant uncertainty in financial forecasting and business valuations, we expect parties to increasingly rely on earnouts to bridge the valuation gap and complete transactions.

2. Other reasons buyers like earnouts

Earnouts allow buyers to defer paying a portion of the purchase price to a later date and fund that payment with the post-closing earnings of the acquired business. This makes earnouts especially attractive for buyers with limited liquidity or that intend for a seller to continue post-closing with the acquired business by providing the seller “skin in the game.”

3. Consider the length of, and the rights of the parties during, the earnout period

The measuring period for reaching an earnout target is typically one to three years. Rarely do they extend beyond five years. While sellers prefer a shorter period so that they can collect their payment sooner, longer periods can benefit buyers by allowing a more accurate picture of an acquired business’s post-closing performance.

Sellers should consider seeking acceleration rights triggered by transformative changes to the buyer—for example, if the buyer sold the acquired business during the earnout period—and audit and information rights, particularly if they expect to be less involved in the day-to-day management of the acquired business after closing.

4. Be specific when defining financial metrics

It is more important than ever to ensure that financial metrics used in earnout provisions are defined with specificity, reflect the accounting standard desired by the parties and take into consideration adjustments used by the buyer when valuing the acquired business or that relate to COVID-specific items. For example, if the target received a Payroll Protection Program (PPP) loan, a traditional EBITDA definition might pick up a forgiven PPP loan as “earnings” if deal documents are otherwise silent. Further, buyers and sellers should consider selecting financial metrics that are relatively simple to apply because complex financial metrics may require significant judgements by one or both parties. Those metrics and judgements can be ripe for future disputes if a buyer or seller is disappointed in the financial performance of the acquired business.

5. Consider what types of interim operating covenants are appropriate

It is common for parties to negotiate whether restrictions on the post-closing operation of the business are appropriate. Sellers prefer covenants requiring buyers to maximize the earnout potential and/or operate the business in the same manner as it was operated prior to closing. Sellers may also wish to retain certain control or consent rights with respect to the business. Buyers typically are reluctant to agree to restrictions that hamstring their ability to run the business as they see fit, especially during the challenging operating environment created by COVID-19. When deal documents are silent as to these types of operating covenants, courts frequently refrain from extending the parties’ implied duties of good faith and fair dealing to mean that buyers have an obligation to maximize a seller’s earnout payments.

6. Consider catch-up and/or proration terms

The pandemic has made it difficult to predict the future performance of certain types of businesses. Instead of relying on an earnout cliff, in which an “all or nothing” payment is made if (and only if) the earnout target is reached, parties might consider more flexible terms that include catch-ups and sliding scales. The former gives sellers the right to earn a catch-up payment if the acquired business does not reach its target for one year but makes up for the deficit in a subsequent year. Under a sliding scale construct, if the target is not met, the seller could still receive a pro-rated portion of the earnout payment.

7. Consider alternate dispute resolution procedures

Parties should consider implementing a separate resolution procedure for disputes relating to the earnout—for example, by identifying an independent accounting firm to determine whether financial targets were achieved. This might reduce the time and expense typically associated with litigation.

8. Consider whether earnouts are really the best option

Keep in mind that earnouts may be helpful to bridge a current financial disconnect but present the potential for future disputes. Courts frequently have observed that “an earnout often converts today’s disagreement over price into tomorrow’s litigation over outcome.”

Please reach out to the Thompson Coburn mergers and acquisitions attorneys below if you would like more information about earnouts or the M&A process generally.

Greg Mennerick, Brent Trame and Michael Rosenblum are members of Thompson Coburn’s Corporate & Securities practice group.