Got An Earn-Out?

In Mergers & Acquisitions, Earn-Outs Can Be Beneficial -- But Also Come With Risk

By Kathryn K. Meier, Esq.
Hoge, Fenton, Jones & Appel, Inc.

What is an earn-out? An earn-out is an arrangement that requires the buyer of a business to pay the seller additional consideration if the business performs as specified after the closing. It can be useful in bridging a gap between the seller’s and buyer’s perception of the value of the business. For example, if the seller believes his business is worth $10 million and the buyer believes it is worth $8 million, they could settle on an initial sale price of $8 million. The earn-out would provide the seller with an additional $2 million if the business performs as the seller believes it will after the sale.

Deciding on a basis for the earn-out. A threshold question is whether to base the earn-out on post-closing revenue, earnings, or other criteria. Basing it on revenue eliminates certain accounting issues, so both the buyer and the seller might prefer it. The buyer must consider, however, whether revenue is really an adequate measure of a business's value.

Use caution! Earn-outs can be an invitation to litigation, so use them with caution. When earn-out provisions lead to disputes it is usually because the parties failed to account adequately for the many factors that can influence the earn-out calculation. For example, the parties should specify the applicable accounting principles. While the use of generally accepted accounting principles is common, the parties might want to deviate from GAAP if one of them has deviated from GAAP in preparing its financial statements. The parties must consider whether to subtract such items as returns, allowances, shipping costs, import and export duties, and sales tax in calculating "revenue." If earnings will be the basis for the earn-out, the parties should consider whether it is appropriate to deduct interest, taxes, depreciation, and/or amortization.

Other things to consider in calculating earn-outs. The following factors also can influence the calculation of revenue and earnings:

• Post-closing sales of products or services at reduced prices by the target to the buyer (if the target continues as a separate legal entity after the closing) or the buyer’s affiliates
• Bundling of the seller's products with other products without a proper price allocation
• Whether the seller will support the business after the closing with appropriate funding for labor, equipment, tooling, marketing, etc. to enable the business to generate the anticipated revenue
• Whether, in the case of an earn-out based on earnings rather than revenue, the buyer will:
  • make expenditures that the seller believes unfairly impact earnings during the earn-out period (such as expenditures for long term research & development ), or
  • improperly allocate centralized or administrative costs among its various subsidiaries or divisions, including the acquired business.

What happens if…? Parties to mergers and acquisitions sometimes fail to take into account other important factors that can affect the ultimate earn-out. For example, what if the buyer sells the acquired business? What if the buyer merges the acquired business entity with another entity? What if the acquired business is integrated into the buyer's other operations so that the revenue and earnings cannot be readily traced? What if the buyer discontinues a product line of the acquired business? If the seller expects to influence post-closing revenue and/or earnings as an employee of or consultant to the buyer, what happens if the seller dies, becomes disabled, or is terminated by the buyer? The earn-out formula should account for these possibilities.

Finally, the seller should have the right to inspect the buyer's post-closing financial records. It should consider the impact that the earn-out will have on its ability to structure the transaction as a tax-free reorganization, or to use the installment method in reporting the gain on the sale.

What should businesses do? An earn-out can be a useful tool in concluding an acquisition. It comes with some risk, however, so knowledgeable and careful legal drafting is critical to protecting your interests.

Kathryn K. Meier frequently conducts workshops for businesses and professional organizations on a variety of topics in the employment law area, including wrongful termination, proprietary agreements, wage and hour compliance, and sexual harassment. Ms. Meier advises her clients on all aspects of human resources issues from pre-hiring through termination of employees. She is an active member of the Santa Clara County Bar Association, and previously served as its President in 1994.