Understanding Earnouts in M&A: Definitions, Payments, and How They Work

The buyer will often want maximum flexibility with respect to how it can operate the acquired business post-closing, especially as circumstances and the business environment changes. The buyer does not want to be hampered by unduly harsh restrictions, covenants, or seller protective provisions. Second, an earnout can work as a motivational and retention mechanism for the seller’s key management team to continue operating the business successfully after the acquisition has closed. For example, a buyer could promise to pay an earnout to a drug company if the product receives US Food and Drug Administration approval within a certain number of years. M&A lawyers are grappling with increasingly complex deal-making processes as clients adopt a tool that lets buyers postpone paying the complete value of a transaction. Sellers often require detailed information rights in the transaction documents to ensure they are able to stay up-to-date on the progress of achieving their earnout targets.

• Even absent documentation issues, earnouts can be an unattractive proposition for sellers.
• You should work with your counsel early on in the process to assist with creating your earnout agreement.
• This blog will explore the earnouts’ ins and outs, how they work, and their essential elements.

Why are Earnouts Used?

To circumvent this, both parties should agree on clear, objective, and achievable metrics. By allowing for payment based on future performance, earn-outs can be the bridge over valuation gaps, offering a more flexible route towards sealing the deal to the satisfaction of both buyer and seller. The earnout adjusts and/or maximizes total purchase consideration based on the seller’s performance over a defined period of time. When an acquirer uses an earnout, they will be able to pay a lesser amount in cash upfront compared with a traditional sales agreement. Overall, earnouts are useful tool in M&A transactions as they provide flexibility over the structure of a deal, while providing sellers with a means for realizing additional, post-acquisition value if the business performs well and above expectations.

Key Elements of Effective Earnout Agreements

Buyers might lean towards more nuanced metrics like net income that reflect true profitability, while sellers often prefer revenue-based targets which are generally less susceptible to manipulation post-sale. This makes them leery of underestimating numbers whereas sellers benefit from potential gains if their business performs in line with agreed metrics leading towards higher overall valuation upon sale of the company. The buyer will almost always want to base the earnout on the seller’s standalone Net Income, while the seller prefers to base it on revenue, partially so the seller can spend a silly amount to reach these revenue targets. Negotiating an earnout can be complex, requiring careful consideration of various factors such as the length of the earnout period, the level of control retained by the seller, and protections against financial manipulations by either party.

These might include revenue milestones, profitability, customer retention, or other specific business objectives. Buyers, on the other hand, can safeguard their interests by conducting thorough due diligence, incorporating performance targets into the deal that truly reflect the business’s potential, and providing for dispute resolution mechanisms in case disagreements over the earn-out arise. For sellers, risk mitigation means insisting on realistic performance targets, ensuring the availability of operational resources, and setting parameters to prevent buyers from unduly influencing the business’s ability to meet those targets post-sale.

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One of the most challenging aspects of M&A is reaching an agreement on the valuation of the target company. Buyers and sellers often have different perspectives on the value of the business, which can lead to significant valuation gaps. On the buyer’s side, if integrating the acquired business swiftly and seamlessly is the primary objective, earn-outs could complicate matters.

The Buyer’s Perspective on Earnouts

Neither Zest DIFC nor Zest Cayman assume any liability for the information provided on the Site. Zest is digitizing private market transactions, building tools to streamline how entrepreneurs, funds, and investors transact. Our platform is designed to save you time and reduce administrative costs, simplifying the end-to-end transaction process. Earnouts can help bridge the gap between a buyer’s and seller’s valuation in an M&A transaction. In this article, we break down everything you need to know about this contractual mechanism. Taxation of earn-out payments can be complex, with the classification as ordinary income or capital gains significantly affecting tax liabilities.

Earnouts serve as a bridge between buyers and sellers by aligning the incentives of both parties. The buyer mitigates risk by deferring part of the payment, while the seller has the opportunity to receive a higher payout if the business performs well post-acquisition. Corporations and holding companies typically make acquisitions using cash from their own balance sheets, while private equity firms and independent sponsors rely on capital from limited partners.

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• Smaller deals tend to have a higher percentage of their total enterprise value (TEV) allocated to earnouts compared to larger ones.
• Metrics such as pipeline development, market inclusion, and the discount rate are vital for accurate performance tracking and valuation.
• Sellers must protect themselves from too much risk, such as earn-out targets that are unattainable, while buyers need to prevent situations where short-term decisions made to achieve earn-out goals are detrimental to the long-term health of the company.
• The buyer does not want to be hampered by unduly harsh restrictions, covenants, or seller protective provisions.
• There is often a tension between the buyer’s desire to minimize payouts and the seller’s goal of maximizing the performance of the business.

Essentially, the earnout period should be long enough for managers to achieve their goals, but not so long that it causes operational difficulties. An earnout refers to a contractual arrangement that provides the seller of a business with additional compensation if the business goes on to meet pre-agreed financial goals in the future. Typically, an earnout will be a percentage of the gross sale or earnings of that business. As we come to a close discussing earnouts, let’s quickly review some helpful advice that can make the arrangement beneficial for both buyers and sellers.

For instance, if the target company exceeds an EBITDA of $5 million, a 10% earnout is triggered, and the earnout level rises to 15% above $7 million EBITDA and 20% above $10 million EBITDA. It is heavily negotiated between the parties, and there is no standard one-size-fits-all approach to earnouts. Earnouts that represent a greater percentage of TEV are, on the margin, more frequently attained. This would suggest that increasing the portion of the total TEV structured as an earnout has its benefits, as management teams have greater skin in the game to outperform. Earnouts reduce the speed of transactions and can increase the number of billable hours lawyers need to spend on the process. Learn how buyers finance an acquisition and what to keep in mind when considering capital sources.

Former investors in Cephalon filed suit, claiming breach and seeking up to $200 million in unpaid milestone payments related to the esophagus treatment. Using an earnout can help get a deal done if the buyer and seller cannot agree on the value of the target business or if the buyer requires third-party financing to complete the deal. In addition to an upfront payment made when the transaction closes, an earnout adds one or more payments based on agreed goals or milestones triggering future payments to the seller. If structured properly and drafted carefully, earnouts can close the perceived target business valuation gap and align the parties by sharing in future financial risks and benefits.

Following a bench trial, the court held, among other things, that J&J’s efforts toward the iPlatform regulatory milestones were not commercially reasonable and J&J had failed to act in good faith and with diligence to achieve the agreed-upon goals. This was especially evident when compared to J&J’s efforts for its only other priority medical device at a similar stage in product lifecycle—an internal orthopedic robotically assisted surgical device (“Velys”). In particular, the court determined that iPlatform was not developed using an industry standard minimally viable product development strategy, while Velys was.

For instance, a renewed focus on profitability has seen more companies making earnouts contingent on earnings performance rather than revenue. Today, we’re sharing a select set of Axial platform data from successfully consummated transactions that included an earnout element in the deal structure. The Earnout Payments will continue for a period of three (3) years after the Closing Date (the “Earnout Period”). The lenders accomplish this by prioritizing themselves over other parties when collecting repayment from a debtor using a subordination agreement, limiting the size of earnouts or even blocking them in credit agreements.

Ensure that you have consensus on the scope of authority for the seller too – they should have a fair degree of control over the ability to meet the earn-out targets without undue interference. Both parties should consider engaging financial and legal advisors who specialize in M&A to navigate the complexities of earn-out agreements, and it might be wise to involve a neutral third-party to monitor and report on the achievement of earn-out targets. It’s all about crafting an agreement where the seller’s actions, driven by the desire to meet earn-out criteria, dovetail beautifully with the strategic goals and vision of the business. This harmony keeps the company on a path to success and ensures that both the buyer’s investment and the seller’s legacy thrive. They are confident in the future performance of their business and see earn-outs as an avenue to share in the future profits that their hard work will continue to yield. There’s also an added layer of assurance; if they believe the business is worth more than the initial offer, earn-outs provide a potential to prove it and get compensated for that extra value.

It allows the acquirer to align their investment with future growth, measured by metrics such as EBITDA targets, gross sales, or specific valuation ranges. Alexion Pharmaceuticals, Inc. (“Alexion”) acquired Syntimmune, Inc., a company developing a monoclonal antibody (“ALXN1830”), with up to $800 million in earnout payments tied to the achievement of eight milestones. Post-acquisition, Alexion had sole discretion over business operations, subject to Alexion’s obligation to use a defined standard of CRE to achieve each of the milestones. The CRE standard was measured by reference to typical biopharmaceutical companies similar in size and scope to Alexion for the development and commercialization of similar products at similar stages, taking into account 11 factors, including profitability. Because the merger agreement did not explicitly allow Alexion to consider its own efforts and cost (unlike in Himawan, discussed above), the court found that Alexion could consider only “typical factors considered by typical companies” and not its own self-interests.

Considering you managed to meet the expected growth targets, here is what the deal structure could look like. The court held that, unlike instances where a buyer covenants to use some level of efforts to achieve the milestone, Medtronic secured itself sole discretion to take actions it knew would frustrate the milestone, so long as the action had some other primary purpose. The court ultimately dismissed the claim on a motion to dismiss, holding that the plaintiff failed to plead any facts that directly earnout data from m&a deals related to Medtronic’s purpose in taking the at-issue actions. Importantly, however, the court acknowledged that the plaintiff could have used circumstantial evidence of an action’s purpose to support its claim and would not have been limited to direct evidence of Medtronic’s primary purpose for taking various actions—it had just failed to do so. You see them most often when the buyer and the seller disagree on the seller’s value or expected financial performance in the future.

The merger agreement provided for up to $2.35 billion in earnout payments tied to achievement of two commercial and eight regulatory milestones. J&J was required to use a subjective CRE standard to achieve each of the regulatory milestones, taking into account 10 listed factors. CRE was defined by the usual practice of J&J and its affiliates with respect to “priority” medical device products of similar commercial potential and at a similar stage in product lifecycle to the acquired assets. J&J was specifically prohibited from taking into account the cost of any earnout payment, and the merger agreement did not specify that J&J had complete discretion over decisions relating to the acquired business.

In the first quarter of 2023, more than four times as many dockets mentioning earnouts were filed in the Delaware Chancery Court compared to the same period a year earlier. Begin by keeping terms simple and straightforward—complex metrics and convoluted formulas can muddle understanding and lead to disagreements. It’s like building a piece of furniture; the fewer pieces and clearer the instructions, the better the outcome.