Got An Earn-Out?
In Mergers & Acquisitions, Earn-Outs Can Be Beneficial -- But Also Come With
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,
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
- 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
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.