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Understanding the Earnout Clause in M&A: Opportunities and Pitfalls


Earno

In the dynamic world of mergers and acquisitions, the earnout clause often appears as a savior, bridging valuation gaps between buyers and sellers. However, while it promises alignment and future rewards, navigating it can be akin to sailing choppy waters. Marein Smits of Wintertaling perfectly explained today at an expert session organised by the DCFA at Nijenrode how to sail choppy waters.

Her introduction title: “Between Scylla en Charybdis” meaning a situation where one must choose between two equally perilous alternatives, essentially a no-win scenario, spoke volumes.

 

🎯 What is an Earnout?

An earnout is a contractual provision (often in the LOI) in the M&A process where additional compensation is promised to the sellers based on the future performance of the business. This can seem like a win-win; sellers receive further value if their former business thrives, and buyers mitigate risk by tying some payment to actual performance.

 

🚧 But Here's the Catch:

 

1. Complexity in Measurement:

Setting clear, fair metrics that accurately reflect performance is crucial. Misalignment on these metrics can lead to significant disputes. What metrics are we tracking? Revenue, EBITDA (with or without holding charges), net profit (with or without normalizations)? Each has its nuances and can be influenced differently post-acquisition.

 

2. Integration vs. Independence:

Post-deal, the buyer usually integrates the acquired company, which might alter its operational ethos or market strategy. This often leads to conflicts if the integration (or any new relations with other businesses) impacts the agreed-upon earnout targets. How much control does the seller retain, if any, to ensure they meet earnout criteria? What in case of an early change of control?

 

3. Timeframe Tensions:

Earnouts are not forever. They have a set period, and pressure mounts as the clock ticks. This can incentivize short-term strategies that may not be in the long-term interest of the business. Is the earnout only paid when the seller is employed at the business? So what happens when the seller for whatever reason has left?

 

4. Legal and Financial Risks:

Earnouts can lead to legal disputes, for instance if either party feels the terms were not met, were manipulated or the buyer was not able to pay. These scenarios can quickly escalate from business negotiations to courtroom battles, incurring significant costs and potential reputational damage.

 

👥 So, What Should You Do?

If you're considering an earnout:

- Clearly define performance metrics, conditions and normalizations.

- Make the earnout part of the purchase price.

- Agree on a realistic timeframe (and conditions related to timeframe) for achieving earnout targets.

- Establish dispute resolution mechanisms upfront.

- Insert a penalty clause for breach.

- Exclude set-off against warranty claims.

- Consult with financial and legal experts to draft airtight agreements.

- Leverage an escrow account or any other security (e.g. parent guarantee, add-on to vendor loan).

- Consider alternatives: carve out (separate sale), pre-exit, pre-sale milestones, vendor loan

- As a seller; “The best defense is a good offense”, propose an earnout from the start.

 

Earnouts are not inherently problematic but require careful planning, clear communication, and solid legal frameworks to be effective. Want to discuss your earnout?

You can always reach us on info@crossings-advisory.com or on +31 (0)85 2006244.

 

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