Navigating earnouts: pros, cons, and how they work

Whether it's a merger, acquisition or sale, a deal is a stressful time for stakeholders on both sides of the negotiating table. An additional factor that can complicate discussions during this time is the earnout clause.

Earnouts are designed to bring parties together when there is a conflict over a deal price, and they can significantly change the financial outcome of a deal for founders and/or key employees. So how can companies prepare for earnout negotiations and deliver earnout clauses that work for all parties?

What is an earnout?

An earnout is a clause in a contract that provides for additional compensation to selling parties if certain performance targets are hit. Earnouts are most often used in commercial transactions like mergers or acquisitions.

Earnouts are especially useful when there is a disagreement between the buyer and seller on the business's forward-looking financial performance, or concerning expected shareholder returns. Because they provide a form of contingency payment dependent on performance, earnouts are often found in high-growth industries where revenues and earnings may be less predictable.

How earnouts work

Earnouts tend to pertain to individuals rather than corporate entities. Data from Grant Thornton suggests that around 40% of deals feature some form of earnout.

Earnout clauses are typically found in the share purchase agreement (SPA), a legal document drawn up during the dealmaking process. The SPA is designed to bring clarity to the terms of any earnout payments. The agreement normally covers a range of variables which differ from deal to deal. These can include:

• Payment structure: the earnout may be a flat fee, such as "€1 million earnout if revenues hit €100 million in the financial year post closing." Alternatively, the earnout may operate with a ratchet, such as a €100 increase in the earnout for every, say, €1,000 earned over a revenue or earnings target. This calculation would mean that if a company overachieved its revenue goals by €10 million, the earnout payment due would be €1 million.
  Earnout payments may be cash, equity, or a combination of both.
• The earnout period: Earnouts are not short-term instruments. The deal's SPA commonly codifies a timeframe of between one and five years for any financial milestones and earnout-related targets to be hit. If earnout payments are staged annually, the amounts or percentages should be detailed in writing.
• Performance metrics: the principal metric used to define an earnout is normally either revenue or earnings/profits. However, it is possible for multiple operational and financial metrics to be used in tandem: a revenue growth target might be coupled with growth in average customer value, for instance.
• Tax considerations: Earnouts are normally taxed as capital gains. In the UK this would mean a tax rate of 20% on gains from the earnout, but if the relevant individuals meet certain conditions they may be eligible for Business Asset Disposal Relief, which could reduce tax further to 10%. (Of course, you should speak to a professional before making any financial or tax decision.)

The advantages of earnout payments

Earnouts can bring

Bridging valuation gaps, and future financial performance

Earnouts provide a mechanism to bridge gaps in valuation expectations between the buyer and seller, facilitating a smoother negotiation process. Although both parties share a common goal of ensuring the success and growth of the acquired business, without an earnout the motivations and desired growth strategies of buyer and seller may differ. If the target company believes that the business will perform strongly in the years ahead, and that this level of performance is not being recognised in the terms of the deal itself, an earnout clause can provide an additional incentive and reward for the seller.

Risk mitigation

Earnouts can also help to mitigate the buyer's risk  By tying a portion of the purchase price to future performance, buyers can mitigate the risk associated with overestimating the business's potential and ensure that the seller has a vested interest in post-acquisition success. Earnouts can also mitigate risk of underpayment for the seller, with contingent payments due if the business performs well post-acquisition.

Flexibility in deal structuring

Earnouts offer parties more flexibility in structuring deals, allowing buyers to allocate a portion of the purchase price based on the business's future performance. Because buyers and sellers can agree a mutually satisfactory metric (or metrics) to define how and when the earnout is achieved, each earnout reflects the goals and strategic priorities of the business in question.

Challenges and risks

Personal vs business performance

The SPA must provide clear guidance as to when the criteria for any contingent payments are met, as well as the purpose of the targets themselves. For instance, if a target metric focuses on individual performance – such as tenure with the new organisation post-merger – there is potentially a stronger case to tax the payment as income rather than as capital gains.

Income taxes are invariably significantly higher than capital gains taxes, so it is in the seller's interest to ensure everything is clearly laid out in the SPA. To learn more, read the interpretation of His Majesty's Revenue and Customs (HMRC), the UK's tax authority, here.

Disagreements on metrics and measurement

The inherent unpredictability of future business performance introduces uncertainty into earnout agreements, posing a challenge in accurately estimating potential payouts.

There are often differences in opinion on the appropriate performance metrics and measurement methods to use in an earnout clause. For instance, a renewed focus on profitability has seen more companies making earnouts contingent on earnings performance rather than revenue.

Law firm Goodwin found that between 2020 and 2022, the proportion of earnouts that were dependent on earnings before interest, taxation, depreciation and amortisation (EBITDA) rose by 22%, while the earnouts that depended on hitting revenue targets decreased by 23%.

And sellers in particular should be watchful for any unorthodox application of accounting principles so that (for instance) the business's earnings for a given financial period miss the agreed milestone for earnout payments. It may be advisable for the SPA to explicitly stipulate adherence to generally accepted accounting principles (GAAP) methods, or international financial reporting standards (IFRS), to mitigate risk here.  

Operational integration issues

Challenges may arise in integrating the acquired business into the existing operations of the buyer, affecting the ability to meet earnout targets. For instance, the seller may request sufficient operational control to give them some influence over whether or not performance targets are met. If not executed with care, accommodating the seller's wishes here may necessitate organisational changes that disrupt other business goals.

Cultural challenges

As with any sale or acquisition, misalignment of cultures and operational practices between an acquired company and the acquirer can impede the successful achievement of earnout goals. Earnouts are designed to bridge the gap between "the seller's rosy forecast and the buyer's healthy scepticism", perhaps implying that some degree of cultural clash is inevitable. For this reason, setting out a process to debate and resolve disputes as and when they arise can be a useful step in the initial negotiation and drafting phase.

Help M&A run smoothly with earnouts

Earnouts can smooth the passage of a deal towards completion and resolve a valuation gap when one presents itself. But they can be the source of numerous conflicts. Parties should seek to base agreements on accurate and unambiguous documentation, and agree the cadence and timeline for earn out payments as a priority. Taking these steps will help earnouts deliver value for all stakeholders.

FAQs

How common are earnouts?

Earnouts are especially common in high-growth segments where future revenue and profitability targets are harder to predict, making a contingent payment potentially more attractive. Sectors that see a higher proportion of earnouts built into transactions include technology, healthcare, marketing and advertising.

What is an alternative to earnouts?

Staggered payments are one potential alternative to earnouts. Staggered payments occur when the seller's shareholding is offloaded in tranches over time. With this kind of arrangement it is particularly important to agree on a formula to determine fair market value for the shares, to be included in the SPA.