An “earnout” is a contractual mechanism in a merger or acquisition agreement, which provides for contingent additional payments from a buyer of a company to the seller’s shareholders. Earnouts are typically “earned” if the business acquired meets certain financial or other milestones after the acquisition is closed.
An earnout can be useful if the parties are having difficulty reaching agreement on an upfront cash price, with the earnout as a way of bridging the different views on valuation of the buyer and seller.
Earnouts are primarily used in connection with acquisitions of privately held companies, although in some rare instances earnouts are incorporated in acquisitions of publicly held companies.
Earnouts often lead to disputes between the seller and buyer as to whether the earnout was in fact earned or whether the buyer improperly prevented the earnout from being maximized.
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In this article, I discuss the important business, legal, and drafting considerations for earnouts to minimize the likelihood of disputes.
The Buyer’s Perspective on Earnouts
Buyers view earnouts as providing several benefits. First, the total price to be paid for the acquisition can be based on the seller’s future performance rather than solely on the seller’s projected performance. This can minimize a buyer’s risk of overpaying for a company.
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.
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. There is direct tension on this issue between seller and buyer.