Drafting Considerations for Attorneys Blog Series – M&A Earnouts

The fields of law, accounting and valuation are only continuing to become more complex.  Given the overlap in these areas of specialty, it is increasingly important for attorneys to have an understanding of the accounting, tax and valuation effects of the legal agreements they draft.  Armed with this knowledge, lawyers can produce the intended outcome for their clients and minimize unintentional consequences and compliance burdens.  

Earnouts

Every transaction is different and determining the purchase price can be difficult based on the complexity of the terms of the purchase agreement.  Typical components of a purchase price are as follows:

• Cash paid at closing
• Deferred cash payments (defined time and amount)
• Stock issued
• Earnouts/Contingent consideration
• Working capital, cash and other targets/adjustments

Earnouts (also referred to as “contingent consideration”) are additional payments that a buyer may be required to make to the seller based on future company performance.  Earnouts are often used in transactions to bridge the gap between what a buyer is willing to pay at closing and what a seller wants in the way of total consideration to complete a deal.  Therefore, earnouts are typically constructed to allow the seller to enjoy additional upside if the acquired company reaches certain performance targets after the sale, while providing the buyer with downside protection in the event that the projected performance after the deal closes does not materialize.

Earnouts can be based on any number of financial (revenue, EBITDA, earnings, etc.) and non-financial (number of customers, number of stores opened, obtaining a project, etc.) metrics.  When earnouts are based on financial metrics, sellers often want the metric to be “higher up” on the income statement (such as revenue) in order to reduce the potential for the buyer to manipulate the company’s post-sale activity to minimize the earnout payment.

GAAP requires that earnouts be valued and recorded as a component of the purchase price.  Even though the exact amount that will be paid under an earnout is not known on the transaction date, its fair value must still be determined and recorded.  The value of an earnout is based on the likelihood of payment and the potential payments amounts.  Oftentimes earnouts are complex and may require the use of Monte Carlo simulations and modeling to determine their fair value.  It is important to note that the earnout liability needs to be revalued each reporting period until it is finally settled, so quarterly/annual earnout valuations may be necessary for financial statement preparation purposes for longer-term earnouts.

When drafting earnout agreements, thought needs to be given as to whether the earnout payments to certain individuals will be contingent upon their continued employment.  If this is the case, rather than the earnout being considered as part of the purchase price, it instead must be expensed over the required service period for accounting purposes.  This can come as a surprise to many acquirers, and may represent a significant additional expense for accounting purposes, so it is important to make sure that the terms of the earnout produce the desired legal, financial and accounting outcome.

Continue reading about the key accounting, tax and valuation considerations of buy-sell agreements in our e-book: Drafting Considerations for Attorneys: Buy-Sell Agreements, Accounting, Tax and Valuation Issues.