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Back Office A Clean Exit Understanding earnouts in a business transaction by Phil Josephson “If you don’t want to work you have to work to earn enough money so that you won’t have to work.” - Ogden Nash An earnout agreement is useful between a buyer and a seller of a closely held business, particularly when the seller and the buyer have different views on the price of the business or when used as a financing device to consummate a transaction. An earnout agreement is a portion of the selling price which is made contingent upon attainment of identified thresholds. While useful, earnouts have downsides and are inherent with litigation risk. Drafting an earnout can be difficult, especially when anticipating all possible future scenarios. As a result, earnout language may be ambiguous, and those that do not draft adequately may invite and encourage future litigation. Loosely drafted earnouts may lead to litigation issues such as implied covenants to use reasonable efforts to develop and promote the acquired business, making representations that buyer can make earnout payments, revenues of another target acquired during the earnout period applied to the earnout, integration of the acquired business as a trigger to an acceleration of the earnout due to a merger, or misrepresentations by the seller that lead to skewed earnout payments. Another issue arises when trying to enforce an earnout. In such cases, courts have had trouble proving or calculating damages. But earnouts do not need to be invitations to litigation. Parties should pay close attention to the accounting, tax, securities, financial and non-financial consequences of each aspect of the earnout agreement. They should specify in detail the nature of the threshold 42 | InsideOutdoor | Fall 2011 • Accounting • Availability of Capital • Management • Change in Control • Tax Impact Structuring an Earnout Issues for Consideration • Earnout Amount • Earnout Period • Performance Goals • Payment Schedule • Operational Integration giving rise to the earnout obligation, the sellers, since they will not be affected methods that will be used in ascertaining by operating expenses or acquisitions. whether Would the earnout your buying has been patterns achieved, change Buyers generally favor net income the for inclusions large and brands exclusions that from you already thresholds stock on the ground that they are the if earnout they calculation, decided and to who start will selling the direct best indicator of the target’s success. determine to customers whether the on earnout their threshold Web siteWhen net income, EBIT or EBITDA are had been met. Careful planning and used as the performance measures, the Yes, I would stop buying consideration of all from possible that Brand scenarios 11% seller should ascertain what administrative at the Yes, initial I would drafting buy as little will, as in possible the future, or general overhead expenses the buyer from the brand 19% minimize risk, avoid conflict and help will allocate to the target after closing and Yes, I would reduce my buying resolve any disputes. from that brand determine 34% how those expense will impact No, I would not change my buying from that brand 13% Earnout language may be I am not sure 23% Source: Shopatron ambiguous and those that do not draft adequately may invite and encourage future litigation. Outdoor Participation, 2006 to 2010 In the earnout agreement, the the post-closing figures. identified thresholds used may be Other areas for drafting consideration Total Outdoor Outings fixed or variable, and they may be nonfinancial 11.6 Billion or financial, 11.4 Billion or a 11.2 include whether the seller will require combination Billion of that the buyer adequately fund the target all. Non-financial thresholds may include 10.1 Billion 10.1 Billion during the earnout period so that it will reaching certain Number milestones of Participants or achieving be able to capitalize on opportunities, other identifiable 138.4 Billion goals. or whether the seller will request a 137.8 Billion 137.9 Billion Financial thresholds 135.9 also Billion 134.4 Billion may vary provision that prevents the buyer from in their composition. Revenue-based making subsequent acquisitions that Participation Rate thresholds are more attractive to would affect the acquired business, or 49.1% 50.0% 48.6% 48.9% 48.6%
Back Office whether the target or a portion of it may be sold to a third party during the earnout period and the effect of such a sale should it happen, or whether anything happens if a third party acquires the buyer during the earnout. If the acquired business will be fully integrated into the buyer’s business or when the business lines of the buyer and the target are essentially the same, it may be harder to measure the financial performance of the acquired business accurately. Therefore, the buyer may want to consider including a provision whereby the seller acknowledges that the buyer has the right to control the acquired business in its sole discretion and the seller waives certain duties. Also, knowing that conflict may be inevitable, the parties should also consider how they want to resolve any possible future disputes, whether by accountants, lawyers, business valuators, the courts, arbitration or otherwise. Earnout periods vary and risk shifts as the length of time extends, therefore, the parties must consider the impact on the business over this time. In addition, the parties should consider events that may terminate the earnout. That could include a buyer wanting the right to terminate the earnout and paying the seller a predetermined amount if the buyer, for example, finds that the earnout would interfere with an acquisition or reorganization it would like to accomplish. A seller may want to terminate an earnout if the buyer subsequently has a change in control that could jeopardize the relationship or payments. Also, an equity raise, an IPO, a recapitalization or other change in resources, management or line of business may be used as a trigger to terminate or accelerate an earnout. Earnout agreements are an often used and effective vehicle in the sale of a business. Each earnout is unique and has nuances. Therefore for each earnout, it is important to consider future scenarios, make the language clear, confer with advisors and draft accordingly. Philip Josephson is the founder of Sterling Business Law, which focuses on providing general counsel and strategic planning services to business leaders and business owners. Josephson earned a bachelor of business administration degree in finance from the University of Miami, a juris doctorate from the University of Miami School of Law, and a master’s degree in business administration from Columbia Business School. He is a member of the Florida Bar, the Arizona Bar and the Federal Communications Bar. Phil can be reached at 305.443.3444 or josephson@ sterlingbusinesslaw.com Fall 2011 | InsideOutdoor | 43
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