What is an earnout? A brief rundown

This article was originally published by BDO in UK

What is an earnout?

Earnouts are a portion of the purchase consideration paid for businesses which is contingent upon the business's performance, after the sale. They are often linked to a post-deal earnings before interest, tax, depreciation and amortisation (EBITDA) target but can also be driven by revenue, different profit measures or other key performance indicators (KPIs), depending on the circumstances.

An earnout can allow the seller to benefit from additional compensation if the business performs well, and the buyer may be afforded some protection against underperformance. An earnout may bridge the gap in price expectations which result from different views on expected future performance of the business, between a buyer and seller.

How does an earnout work?

The Share Purchase Agreement (SPA) defines the metric used to calculate the earnout. Normalised EBITDA is commonly used. If the metric is achieved, an earnout is typically paid in cash to sellers following the end of the relevant period but may, sometimes, be paid in shares in the purchasing company (or its parent entity).

An earnout is often linked to a multiplier. For example, for every dollar in excess of a minimum EBITDA, the earnout could be a multiple of 5x. The earnout can then be easily skewed by a relatively small impact on the profit metric. By way of a simple example, sellers might receive a multiple of 5x for every one dollar that EBITDA is exceeded over a certain amount (e.g. $2 million) but nothing if it is less than $2 million. So, if the business achieved EBITDA of $2.3 million for the period, the earnout would be $1.5 million ($300,000 x 5).

The opening position should be carefully accounted for, as any material errors in the opening balance sheet at the start of the earnout period may impact the earnings during the period. The parties may, therefore, want the opportunity to review and amend the opening position if relevant or align it with the position in the completion accounts (if prepared).

What are the pitfalls of an earnout?

Whilst an earnout may look like a simple way to bridge the gap between a buyer and seller’s expectations, there are also risks and areas in respect of an earnout where we commonly see disputes arise.

Tying sellers into the business can be a double-edged sword. Their expertise can help the business to maintain its performance, but if there is a dispute over the earnout calculations at the end of year one, it can jeopardise performance over the rest of the earnout period.

An earnout could also encourage sub-optimal short-term behaviours for the business’ longer-term performance, like reducing margins to increase volumes or cutting marketing expenditure. Conversely, a buyer could recruit additional staff to take a short-term hit during the earnout period, but a long-term gain.

Good/bad leaver provisions

It is common to have provisions that set out the parties’ required conduct during the earnout period. These ‘good/bad leaver’ provisions set out details of the circumstances in which sellers who remain within the business post-completion may and may not be entitled to leave the business within the earnout period. These types of provisions can be used against sellers to reduce or avoid earnout payments if they are considered bad leavers or in breach of their conduct provisions post-completion.

A typical earnout period is one or two years. Sellers usually remain in the business throughout this period and meet buyer expectations of performance to extract the full value of their shares.

Given the importance of these provisions to both parties, they need to be clearly drafted by appropriate legal professionals. The provisions need to ensure the sellers remaining in the business know what is expected of them and provide sufficient comfort and security for their employment within the business. Similarly, the buyer will want the ability to remove a seller from the business if they are underperforming.

Accounting issues and areas of disputes

The accounting hierarchy

The earnout schedule to the SPA will typically set out the order of priority for accounting policies or rules used in the calculation for the earnout.

Typically, the accounting hierarchy will be in the following order of priority:

Specific accounting policies/adjustments to the earnings measure (e.g. EBITDA) (expressly agreed between the parties)
Accounting policies/principles/basis used in the preparation of the buyer’s accounts/sellers’ accounts
IFRS or Australian Accounting Standards (AASB’s).

Accounting policies are another common area of tension between sellers, who prefer their accounting policies from when they owned the business, and buyers, who will want to use their own accounting policies.

The buyer may want to use their own accounting policies as the basis for preparing the reference/relevant accounts for the earnout. Adopting a different policy can significantly impact the metric being used to calculate the earnout. A buyer has a clear incentive to use their own policies or manipulate them if it results in a lower earnout.

Sellers typically resist the imposition of policies from the buyer to minimise the risk of manipulation. They should try to ensure the same basis of preparation and policies is used to prepare the earnout amount and mechanism during negotiations.

The specific policies will be a point of negotiation and should be well defined in the SPA.

Calculation of the key earnout metric

Each party will try to protect their own interest and the choice of metric is a key factor. The SPA needs to tightly define the metric to be used, for example Normalised EBITDA, and how it should be calculated.

Impact of multiplier/ratchet mechanism

As explained in the earlier example of how an earnout typically works, it is common for an earnout to be linked to a multiplier depending on the level of earnings achieved. The actual impact of a dollar adjustment to EBITDA in a dispute can then be worth far more to the parties due to the multiplier being used. It is possible for the earnout amount to be changed by a relatively small impact on the relevant metric.

Resolution of earnout disputes

When it is not possible for the parties to reach a full settlement of an earn-out dispute, the SPA will usually specify that the dispute should proceed to an expert determination. This is usually an independent accountant with experience in M&A matters, instructed by both parties.

BDO can assist with your earnout accounts

BDO’s transaction services team is experienced in advising on earnouts and associated accounting policies or acting as an independent accountant if there is a dispute. We can assist with accounting implications, review requirements for the sale and purchase agreement, and review at completion.

Get in touch to discuss how we can assist with your earnout agreement.