The most important part of buying or selling a business is the bottom line – how much money will the buyer have to pay, and how much will the seller receive? No one can guarantee that the business will profit in the future, so one method for making the purchase price consistent with future performance is an “earnout provision.”
An earnout provision makes the purchase price (typically, some part of it) payable in the future dependent on the buyer’s financial performance. Whereas some business sales are for a fixed price, payable at closing, an earnout provision allows for payment to be made over time according to a fixed formula.
Earnout Provisions
When drafting an earnout provision in an asset purchase agreement, the attorney’s role is to define what the benchmarks are for the payment, how they will be measured, and how the corresponding payment will be calculated. For example, will the buyer and seller use gross revenue benchmarks, EBITDA, or a margin? Each calculation of the earnout is different, subject to different variations – and even manipulations.
A few examples of earnout provisions are as follows:
· A sliding scale approach where the earnout is adjusted on a dollar-for-dollar basis depending on a given calculation,
· A tiered approach, where the seller is paid a different amount depending on performance within various defined ranges, and/or
· These might be subject to a minimum (floor) or a maximum (ceiling).
Buyers and sellers can be as creative as they want when coming up with an earnout formula that works for their particular deal. An earnout, properly structured, helps to bring buyers and sellers together. It gives buyers a way to align the payment price with revenue generation, and it gives sellers the opportunity to increase their payout.
Structuring a Payout
There are a couple of possible issues to be aware of when structuring a payout, however. The buyer and their accountant may have various ways to characterize things like expenses, investments, and other aspects of the financials that could affect the earnout calculation. For that reason, such issues should be decided in advance when possible, and the seller should have the ability to review the buyer’s books and records.
A second issue is how such disputes about the earnout calculation should be resolved. A lawsuit or arbitration is likely to cause significant delays and increased expenses, often holding up payment to both buyer and seller while the dispute is pending. In our office’s experience, one solution is to select a neutral third party in advance to decide these disputes.
All in all, an earnout provision can be an important way to ensure that a business purchase and sale gets all the way to closing. The buyer and seller should carefully consider all aspects of the earnout payment with experienced legal counsel to find a transaction structure that benefits all parties.
Dye Culik PC is a Charlotte, North Carolina business law firm representing entrepreneurs, business owners, and investors in all aspects of mergers and acquisitions, as well as in other corporate legal issues and disputes. If you are considering buying or selling a business, contact us to see how we can help you close the deal.