I’ve spent a few blog posts on what situations earnouts are used and how often they are used. This last post on earnouts covers how to structure an earnout.
Earnout Period
In summary, make the earnout period not too short, not too long. Too short and the seller has an incentive to act in a completely short term manner, possibly playing games with trading long term revenue with short term. Too long and it can delay and impact the integration with the buying company and/or new owner. Earnout periods of eighteen months to 3 years are the most common, but of I’ve seen them out much further.
The length of the earnout also often depends and coincides with how long the seller is still involved in the business. Naturally, the seller wants some control of the company during the earnout period to make sure the company achieves the targets.
From a study of over 100 middle market transactions by the American Bar Association in 2009:
- Under 12 months, 4.3%
- 12 to 23 months, 30%
- 24 to 36 months, 36%
- Over 36 months, 29%
Amount of Earnout
It is hard to provide much guidance on the amount, since it completely depends on the deal and how much earnings risk the buyer is trying to mitigate. I’ve done earnouts of 10% of the purchase price to 50% of the purchase price, although 20 to 30% are more common.
Earnout Measurement
A buyer will commonly wish to base an earnout on EBITDA because, after all, that is really what he cares about. A seller’s most common fear is that even if they are still around they will not have complete control over costs and therefore can not control EBITDA. Indeed, an experienced deal attorney once told me this is the issue that causes the most lawsuits after a deal is closed.
For this reason we try hard to negotiate earnouts based on revenue milestones, not EBITDA. If we fail at that, gross margins can also work. Basically, the further up the P&L statement you go, the easier it is to measure earnout.
Interestingly enough, we had a situation where measuring earnout as a percentage of EBITDA was the best solution for the seller. In this case, the seller was performing a myriad of illegal tax maneuvers to lower his taxes, and try as I might, I could not convince him to stop for even one year (for he would pay 40% in taxes, but would receive 400% in increased purchase price for each dollar earned). He admitted that all this would end when the buyer bought the company, and then the buyer would receive a windfall because EBITDA would almost magically be higher. So we negotiated an earnout on an increase in EBITDA, not in revenue and not in gross margin.
You can also measure earnout on events such as signing (or often resigning) a major contract, getting government approval (e.g. FDA approval) or launching a new product.
From two studies of over 200 middle market transactions by the American Bar Association in 2007 and 2009:
- Earnout based on Revenue: 29%
- Earnout based on EBITDA: 32%
- Other: 26
- Unknown: 13%
The transactions in the study were between $20 million and $500 million in size – fairly large. I thin a similar study of smaller deals would find that the use revenue as a measurement occurs more often than the use of earnings.
Earnout Formulas
It is also good to keep in mind that complex formulas based on revenue, gross margins or earnings are problematic when it comes to actually writing a purchase agreement and making sure that months later everyone that reads it will come away with the exact same understanding. It is pretty easy and even fun to brainstorm and draw out graphs and curves, and talk about cliffs and caps. But always keep in mind that you should keep it as simple as possible and that complex agelbra doesn’t translate well into a legal agreement.
Controls and Restrictions
A seller will often say something like, “OK, I’ll live with that earnout based on growth of 15% next year, but in return I want some reassurances – in writing”. These are some of the restrictions or buyer covenants that are often put into place during the earnout period:
- Office will stay in same location
- Key employee(s) will not be terminated
- Sales compensation structure will remain the same
- A certain amount of capital be invested in a project
However, each restriction is a negotiation in itself, which is another reason to keep everything as simple as possible. For example, it is easy to say that a key employee can not be terminated, but what if he commits extortion? You can say that sales compensation will remain the same, but the new company has a different healthcare package they use, and the fact is that some employees can get very passionate about their coverage, personal doctor, etc. You could argue this changes the compensation, so this issue needs to be addressed and covered in the purchase agreement.
In other words, the issues that need to get worked out in earnouts tend to run much deeper than many originally think about. In fact, it isn’t uncommon for earnouts to disappear late in negotiations when the parties figure out there are just too many issues to address and the complexities become apparent.
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