M&A Earnout Provisions – What You Need to Know

2024 SRS Acquiom market data shows that earnout provisions are an increasingly important factor in private-target M&A deal-making.  Because achievement rates are far from guaranteed, and as a result earnouts are susceptible to renegotiation and dispute, it is important for deal parties on both sides to understand what an M&A earnout provision is, why they are used, how they work, and their potential impact on post-closing activities and the total deal valuation. This article provides high-level information on what you need to know about M&A earnout provisions to make informed decisions and maximize the opportunity for a successful M&A transaction. 

What Is An M&A Earnout Provision?  

Earnouts are an effective tool in private-target M&A where additional contingent consideration, often payable upon the post-closing achievement of a business goal, is included with an aim to reduce the buyer’s risk of overpayment while potentially allowing sellers to benefit from now-proven or future performance. Contingent value rights in a public M&A transaction are similar.  

An earnout provision in an M&A agreement is a tool to bridge the gap between the value of the business the seller perceives and a buyer’s willingness to pay that amount up-front.  In approximately one in five of all M&A transactions tracked by SRS Acquiom, the buyer and the seller could not agree on a fixed purchase price paid at closing and, instead, agreed that part of the purchase price would be based on post-closing performance of the target company’s business.   Defining the required business performance, and calculating how much will be paid to the seller, is subject to negotiation and requires consideration of many factors.  The type and size of the target business plays an important role in deciding what factors should be addressed.  For example, performance may be judged on specific financial results, or a combination of revenue and profit factors (such as EBITDA), or achieving operational milestones such as regulatory approval within a certain period after the closing.   The language in the M&A agreement defining the performance goals, appropriate metrics, how payments will be calculated, and when they will be paid, is referred to as the “earnout provision,” or “earnout.”   

Why do M&A Deal Parties Use Earnouts? 

 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.  However, in practice, earnouts frequently miss their target, often require renegotiation after closing, and, if mishandled during the post-closing period, can potentially harm the deal parties’ relationship or reputations.  Sellers should look to data on post-closing earnouts and set their expectations around the total deal value accordingly.   Earnouts should be negotiated and drafted with an eye toward clarity, pragmatism and avoiding post-closing disputes.  

• Benefits for Buyers 

  Earnouts can reduce buyer’s risk of overpaying by allowing them to pay the purchase price in installments with a lower initial payment and future payments based on actual performance of the target business.  Also, it is easier for buyers with cash restrictions, or who require third-party financing, to complete the transaction if the guaranteed upfront payment is lower and future payments are only payable when performance expectations are met. Serial buyers also have reputational considerations when utilizing earnout structures; buyers with strong track records for earnout success may be able to leverage that on future deals. 

• Benefits for Sellers 

  Earnouts allow sellers to benefit from future growth of the target business without requiring the seller to expend additional capital.  If the future business is successful, the seller will receive an overall higher business valuation.  Sometimes the M&A agreement allows seller executives or other key stakeholders to participate in the future business to encourage continuity and influence future growth, which may improve the seller’s earnout payments.  However, seller’s participation in the future business, or lack thereof, can also be a drawback as discussed below.  Receiving installment payments may also reduce, or spread out, the tax burden on the seller. How earnouts are treated for tax and accounting purposes depends on their classification. Tax and accounting considerations related to earnouts are complicated, require the assistance of experienced tax counsel and advisors, and should be addressed early in the M&A process. 

• Potential Drawbacks 

  Choosing the right “dance partner” when engaging in M&A is crucial, and even more important when an earnout is at play. Whether buyer is a known entity or new to M&A, is a financial or strategic buyer, is big or small, or keeps the target’s existing management team in place or fully integrates the business into their own, once the deal closes, that business is owned and controlled by buyer.  

  Buyers may find that allowing seller parties to participate in the post-closing business is disruptive if buyer has a different management style or if seller personnel attempt to boost earnings or influence operations to increase earnout payments in ways that are against the buyer’s preference.   

  Seller parties may be disappointed if they feel they have no influence, inadequate information, no access to current or prior personnel, or if the business changes direction and the earnout payments are reduced or eliminated.  Negotiating and drafting earnout provisions in the M&A agreement is complicated and requires high attention to forecasting and detail.  Depending on the length of the earnout period, it is difficult to predict the future; take into consideration all the factors that may impact the earnout, and draft the earnout provisions to the satisfaction of both parties.  For example, what happens if the buyer changes strategy or modifies its business plan during the earnout period or if government regulations impact the business change?  The M&A agreement should include ways to reasonably address an unpredictable future, such as accommodating post-closing renegotiations if necessary and avoiding drawn-out disputes. 

What are Best Practices for Drafting Earnout Provisions? 

One of the primary reasons deal parties include an earnout in an M&A deal is because they have different opinions about the value of the target business.  This difference of opinion will not be easier to manage over time.  While the deal parties are motivated to come to an agreement and get the deal done, they should thoughtfully discuss and carefully draft the earnout provisions to appropriately set expectations and avoid uncertainty and disputes after the deal closes.   

Recent SRS Acquiom M&A data shows that earnouts achieve about 21 cents on the dollar and are contested at least 28% of the time. Of the 59% of deals that paid anything on the earnout, 17% of them required the earnout to be renegotiated to avoid litigation.  Addressing expectations and details before the deal closes can help get the parties on the same page for a smoother earnout process. 

• Focus on Goals and Outcomes Before Establishing Metrics

  SRS Acquiom recommends deal parties discuss business goals and performance outcomes, as well as which business conditions may change before defining the metrics and milestones triggering earnout payments. Start with the question: what is the business outcome that all deal parties want? Outcomes could include hitting projected growth targets, a set period of trackable stability, achievement of a specific milestone event, or specified financial performance. 

   Due to the difficulty in predicting the future, earnouts should be structured in a way that takes changing business conditions and strategies into account and is not tied to a rigid business plan that exists at closing.  Ongoing monitoring and information rights can help keep expectations in line.   

  Business changes are likely to occur during the earnout period, with is typically 24 months on a median basis.  Identifying changes, variables, and risks common in the target’s business and industry depends on the type, size, maturity, and location of the business.  Generally, deal parties should assess the impact of integration challenges, changes in business strategy, management or personnel, economic or competitive conditions, and the legal or regulatory environment.  Addressing and agreeing upfront how issues will be addressed when determining the earnout will reduce the risk of post-closing dispute.  

  Most deals with earnouts are structured with multiple metrics, which typically operate independently but occasionally “stack” or are cumulative. In businesses where product development cycles are long and interim earnout milestones are necessary, M&A deal parties should consider providing for an alternative or second earnout milestone as an opportunity for an earnout payment (perhaps in an adjusted amount) if business plans change or if a previous milestone is bypassed or delayed rather than simply having the earnout fail. 

  • Unique Challenges of Life Sciences M&A

    Life Sciences M&A deals face many unique challenges and special considerations, including the negotiation of and drafting of earnout provisions. Life sciences earnouts tend to be complex with extended timeframes, and it is common for product development and regulatory plans to change over time.   

    In drug, medical device, and diagnostics sectors, most projects fail to make it through years of expensive, risky research and clinical development to achieve FDA approval and commercial success. Accordingly, buyers pursue a slate of acquisitions to diversify these unavoidable risks and enable them to place more bets in this numbers game. Life science target companies are often acquired during the development stage with accompanying earnout provisions. Sellers have inverse reasons for considering these deals. Exiting their investment earlier with lower invested capital can lock in an initial return, retain upside in the earnout, and avoid the need to keep funding the significant cash burn required for product development. 

    The unique realities of the life sciences industry should be clearly and practically addressed when drafting the earnout provisions, especially given the appreciably larger dollar amounts at play and longer performance periods. 

  Information and Monitoring Rights Benefit All Parties

  Unless the purchase agreement expressly calls for it, the sellers will likely have no visibility into post-closing business operations or financial information.  Even if seller parties have an on-going role in the business, they may not have access to all the information needed to determine if earnouts are on-track. Selling shareholders who are employed by the buyer post-closing can sometimes help keep the other sellers informed but may also have a conflict of interest.  

  It is vitally important that sellers receive periodic, transparent information around all post-closing matters, including earnout achievement or failures. The buyer generally has no legal obligation to provide seller any information not required by the M&A agreement, so the majority of agreements address post-closing reporting and the seller’s information rights.  These rights should detail the information required to accurately portray and understand post-closing business results and support the calculation of earnout target achievement and payout amounts.  

  Well drafted-information rights provide for periodic reports and supporting information to be provided to specified seller representatives, the level of detail required, seller’s right to request meetings, additional information, or access to buyer employees or representatives with requisite knowledge of and control over the information, and the process for the provided information to be fully reviewed, corrected, or disputed, if necessary. 

  Buyers also have a vested interest in keeping sellers informed about progress toward the earnout: managing expectations. Sellers are often optimistic about the future of the business they just sold; sellers’ expectations for the earnout are often high and will remain so if buyer is not providing any kind of reality check along the way. If the answer at the end of the performance period is that none or only a little of the earnout is payable pursuant to the terms, buyers should expect sellers to react accordingly. Be prepared to explain yourself – or better yet, provide regular updates explaining the target business’ performance throughout the earnout performance period. 

  • Be aware of Confidential Information.  The information shared with sellers as part of their information rights is often confidential or proprietary, so the identification, disclosure, and use of such information by seller and its representatives should be specifically addressed. If information rights permit access to current and former employees of the target business, the parameters of what the seller can ask them, and what information can be shared, should be clearly stated so neither the confidential information nor the employee will be at risk. M&A agreements often address confidentiality, which likely applies to the parties with respect to the post-closing earnout. Also note that if the buyer is a publicly traded company, information obtained with respect to earnout achievement not otherwise publicly disclosed may constitute insider information and restrict the ability to freely trade in the buyer’s securities. 
  • Prioritize the Most Important Information Rights.  Sellers, particularly in smaller deals where their leverage might be limited, should prioritize which information rights are most important to address their primary earnout achievement concerns and avoid anxiety during the earnout period. In a contested earnout, sellers might need to show that buyer did not fulfill their contractual requirements when operating the target’s business post-closing, therefore failing to achieve the earnout; this can be challenging to prove to an arbitrator or judge without robust information.  

  Accountability through Operational Covenants and Diligence Standards 

  To help ensure earnout goals are achieved, sellers may impose on buyer certain operational covenants or diligence requirements in the M&A agreement, such as operating the target’s business in accordance with past practices or using commercially reasonable efforts. Sometimes, parties will even agree to binding business plans, budgets, and personnel teams. This is a continually evolving area, with Delaware case law emphasizing the importance of this language. Operational covenants and diligence requirements may be an area where, in practice, the simple fact that the parties had the discussion, early and thoroughly, is the key factor for success, but it is always important to get the drafting right, too. 

  Additional Protective Provisions for Buyers and Sellers 

  Deal parties often address additional specifics relevant to the earnout provision. For example, buyers often have post-closing protection from the sellers via indemnification and earnout payments can serve as additional security for such protection (i.e. buyer can offset an earnout payment if indemnification is owed). On the sell-side, sellers may negotiate for an acceleration provision, making the earnout payable in the event of a change of control (either of the buyer or the target’s business). There may also be language clarifying that the earnout is not a security or does not create a fiduciary relationship between the buyer and sellers. 

  Who Are the Key Players: Why to Engage Expert Advisors 

  In negotiating earnout provisions, it is advisable to select the right team of advisors who have specific expertise in this area.  Close attention to detail, awareness of the industry and potential pitfalls, and skilled drafting are critical to effective earnout provisions and avoid post-closing disputes.   

  It is also important for the parties to select business personnel and a shareholder representative best able to manage the post-closing activities and successfully navigate the relationship between the buyer and seller during the earnout period. A solutions-oriented shareholder representative with the right resources and experience can make the process more efficient and effective. The seller’s shareholder representative must have the technology, time, resources, and expertise to effectively manage the ongoing relationship with the buyer. 

  There is no question that earnouts in M&A transactions are here to stay. Potentially attractive to both buyers and sellers, earnouts can bridge valuation gaps. When negotiating and drafting earnout provisions, a broader perspective focused on outcomes will reduce the potential for disputes and lead to a more positive outcome. The 2024 SRS Acquiom M&A Deal Terms Study and 2024 SRS Acquiom M&A Claims Insights Report can help deal parties understand the data around earnout attainment to inform planning and negotiation strategy.