Earn-Outs Part 2: Limiting the Damage
Last month we covered why earn outs are bad for sellers. This month we’re addressing the fact that as a seller, especially a seller to private equity, earn-outs are a reality that you may sometimes need to accept. If that’s the case, the question becomes how to limit the damage.
As a seller, your goal is to increase (a) the size of the earn out payment and (b) the probability that you receive it. You do this by reducing the buyer’s discretion over the variables that determine the earn-out.
Here are 4 ways to secure the earn-out:
1. What Are Earn-Out Operating Covenants?
Earn-out operating covenants address the problem that, after closing, the buyer controls the business decisions that determine whether the earn-out is achieved. As a result, the seller needs to restrict the buyer’s ability to take or not take actions that affect earn-out performance.
Common protections include:
Restrictions on diverting customers or opportunities to affiliates
Restrictions on delaying revenue to post-earn-out periods and accelerating post-earn-out expenses to the earn out period
Restrictions on discontinuing revenue-generating products or services
Limits on material pricing or strategy changes
Minimum staffing or resource commitments
General restrictions on restructuring that would reduce short-term performance
The best remedy to enforce the operational covenants is the right to “add back” any losses from the earn-out that occurred due to operational breaches by the buyer.
For example, if the buyer intentionally delays sending an invoice until after the earn-out period to suppress earn-out revenue, the seller could increase the revenue numbers by the amount the buyer would’ve achieved had the invoices not been delayed. The same goes for accelerating expenses into the earn-out period to suppress profits.
Pro Tip: Don’t believe that the buyer won’t intentionally engineer the earn-out to avoid paying you. With millions of dollars on the line, the incentive for most buyers is to use their control of the business to suppress the earn-out.
2. What Are Earn-Out Accounting and Calculation Controls?
Even a healthy, growing business can produce a failed earn-out if the calculation is at the buyer’s discretion, which would be the default since the buyer will own the business during the earn-out period.
Therefore, the earn-out formula should be tied to defined accounting rules.
Typical controls include:
Use of consistent historical accounting practices
Defined treatment of extraordinary expenses
Restrictions on new management fees or corporate allocations
Clear allocation rules for shared overhead
A fixed methodology for revenue or profit measurement
Again, the best remedy to enforce the financial earn-out covenants is (like operational covenants) the right to “add back” any losses from the earn-out that occurred due to accounting breaches by the buyer.
For example, if the buyer uses the wrong accounting rules or methods to calculate a suppressed earn-out, the seller can replace those numbers with the corrected numbers that the buyer would’ve calculated had they used the rules and methods negotiated in the purchase agreement.
Pro Tip: The less interpretation required, the more reliable the payout. Clear accounting rules prevent costly litigation.
3. What Are Earn-Out Reporting and Audit Rights?
Without access to financial and operational records, sellers cannot verify the earn-out calculation or detect breaches of operational covenants. Therefore, sellers should seek aggressive audit rights.
Standard protections include:
Monthly or quarterly reporting of relevant financial statements
Access to records reasonably necessary to support financial statements
Right to audit final calculation
Pro Tip: Keep a very close eye on the data that will decide if you get paid your earn-out. If you do not have access to that data without starting a lawsuit, you’re already losing.
4. Why Linear Earn-Out Beats All-or-Northing Earn-Out
The problem with all-or-nothing earn-out is that if you do not reach the earn-out target, you get nothing. This is an unfair outcome in cases where your profits are barely short of the target.
For example, in a situation where:
The earn-out is a $2 million payout after one year if the annual profits in the first year are $2.5 million or more, and
The actual annual profits in the first year are $2.45 million (just $50,000 short of the $2.5million milestone),
Would it be fair for the seller’s payout to be zero when it would have been $2 million if profits were just slightly higher?
Of course not.
On the other hand, in a linear earn-out model, the payouts would be paid proportionally for performance between $2.0mm and $2.5mm in profits.
For example:
$2.5mm or more = $2mm earn-out
$2.375mm = $1.5mm earn-out
$2.25mm = $1mm earn-out
$2.125mm = $0.5mm earn-out
$2mm or less = $0 earn-out
Therefore, to protect sellers who miss the earn out by a small margin, many earn-out provisions provide a partial, proportional earn-out, decreasing until the earn-out reaches zero.
Pro Tip: Most buyers will accept a linear model if you propose it, but they probably won’t offer it themselves, so ask for it.
Final Thought: If you’re going to accept an earn-out and resolve to limit the damage, you need to first decide whether you will fight that fight in the purchase agreement or the letter of intent. If you fight that fight in the letter of intent, you avoid time wasted on a buyer who will not accept the protections you demand. On the other hand, if you wait until the purchase agreement stage to raise these earn-out requests, you may have more leverage over the buyer who at this point has spent substantial time and money on due diligence.