Earnouts are an important part of M&A transactions, with about 20% of all deals involving some form of it in normal circumstances. With COVID-19 at our heels, that percentage is going up as buyers take extra precaution, given the uncertain economic environment we now find ourselves in. Whether you’re a seller or a buyer, it’s important to learn how earnouts work, protect yourself, and strike win-win deals based on mutual trust and understanding. Domenic Rinaldi takes a peek at this timely topic as he sits down with deal attorneys, Jeffrey Petersen of The Law Offices of Jeffrey T. Petersen and John Schreiner of Perkins Coie. With Jeffrey taking the seller’s side and John playing the buyer’s counsel, they trade ideas on how sellers and buyers can make the best deals given their specific circumstances. It’s all you need to know about earnouts in one episode! Be sure not to miss out on it!

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Earnouts In M&A Transactions With Jeffrey Petersen And John Schreiner

In this episode, I had the pleasure of speaking with two very seasoned deal attorneys: Jeff Petersen, from The Law Offices of Jeffrey T. Petersen and John Schreiner of Perkins Coie. We discussed the role that earnouts play in M&A transactions, their application, how to develop good ground rules and how to protect your interests. At a high level, an earnout is a promise of future payments based on some future metrics being achieved. As you can imagine, buyers see earnouts as a great tool to protect their investment especially in this post-COVID environment. Sellers want to avoid earnouts as it means they are walking away from the business with something less than the full purchase price. One thing is for sure, when there’s an earnout involved, you definitely want experienced attorneys like Jeff and John representing your interests.

Before we get into the interview, please head over to K2 Adviser, and take our free seller or buyer assessment. These assessments will help you understand how ready you are for an acquisition or sale. The Buyer Readiness Assessment is at the bottom of the Acquire tab and the Seller Readiness Assessment is at the bottom of the Exit tab. Understanding how prepared you are for an acquisition or sale is imperative to ensuring that you maximize returns and minimize risks. Thank you for being here. I know you will enjoy this conversation with Jeff Petersen and John Schreiner.

M&A Unplugged community, I’m pleased to have back John Schreiner of Perkins Coie and Jeff Petersen of The Law Offices of Jeffrey T. Petersen. Guys, welcome back.

Thanks a lot, Domenic.

We had a great response to the last episode that we did, where you each took a side in the deal. One of you taking the buyer and the other one taking the seller perspective as we broke down indemnifications, reps and warranties. The M&A Unplugged community had some tremendous feedback there. We thought, “Let’s come back for round two and attack something that is a big topic right now, earnouts.” Maybe we could start at the basic level. Let’s talk about what an earnout is. Where do you see it most commonly used? Especially now that we’re in a COVID environment, it’s become more important.

Domenic, for the audience, my name is John Schreiner. I’m a partner in the Corporate and Securities Group with Perkins Coie based out of Chicago. An earnout is essentially a contingent payment. If you are going to sell your company, as a seller, you’re going to have a purchase price and you get 100% of that purchase price paid at closing in cash. Sometimes though a portion of that purchase price will not be paid at closing and it’ll have to be earned after. With an earnout, you have a couple of components. One, you have the amount of the earnout and that can either be a fixed amount or it can be an amount that is based on some formula, for example, percentage of revenues, EBITDA growth, etc. The earnout then is also paid at a specific period of time. That can either be a certain date or a milestone in the future. That’s what an earnout is. However, there are some nuances to it that we’re going to get into.

Jeff, anything to add there?

I would just say this. John is going to take the position of a buyer’s counsel. He’s the bad man looking to put the benchmark on this poor business owner that has to now hit these benchmarks in order to get all the revenue and all the monies to which they’re entitled.

Jeff, when a seller gets ready to bring their business out to the market, they’re hoping to be able to mostly walk away clean. Unless they want to retain a piece of the business because they’re going to stay on with the new management team or they want a second bite of the apple somewhere down the road. Very few people go in thinking, “I’m going to accept this big earnout. I know I’ll get payments later.” Talk to us about the seller’s perspective. How do you work with sellers through this issue? There are many issues that they have with it.

The seller’s perspective is what you said, Domenic. They would love it to get all the money upfront and have that security and certainty. From their perspective, it can be a little bit of a jolt. As they’ve worked with their investment banker, they understand that this is part of the terrain most times. What they’re looking for is certainty. That’s what we’re looking for as well. John had mentioned the earnout calculation, EBITDA growth, percentage of net income, something along those lines. From the seller perspective, we want to have a lot of certainty around a couple of things.

One, how is it going to be calculated? Two, if there is a dispute, how is it going to get resolved? For instance, a lot of times a buyer will say, “We’ll have an independent accountant look at it. What they say goes.” From the seller perspective, you don’t want that to happen because that’s potentially millions of dollars. You want a good accountant looking at it. If it’s worth that much money, it’s worth having a dispute resolution clause that you can go to an arbitrator for. You also want certainty that they’re not going to throw you out and terminate you either as an employer, if there’s a consulting agreement unless there’s a very high threshold that’s been reached.

Let’s dive into a little bit more about why is an earnout necessary. Jeff, let’s take it from the seller’s perspective. As you said, owners don’t want an earnout. It becomes obvious at some point in time for a number of reasons. Maybe we could talk about those reasons where earnouts make sense.

MAU 61 | Earnouts In M&A

Earnouts In M&A: From the seller’s perspective, an earnout can be a little bit of a jolt as they would very much prefer a clean closing.

 

A couple of the big ones right up the top is you can’t come to terms on evaluation. There’s a gap there that needs to be bridged. The seller thinks the business is worth more. The buyer isn’t so certain and also from the buyer perspective, if I can step out of the shoes of seller’s counsel for a moment, it’s not a turnkey operation. You’re going to need the principals involved so that they can maximize the benefits of the purchase. You want those principles to be incentivized to keep working hard for a couple of years going forward.

I would imagine now too, what we’re seeing from a seller’s perspective is if their business has been impacted by COVID, they still see this pre-COVID value. Maybe the business isn’t back to that point yet, but they still want to sell. In order to realize that full value, maybe an earnout bridges that gap in the short-term. If the business does return, then they’ll be able to realize what was previously the full value.

I also think even if the business may not be impacted that buyers are looking more toward an earnout now. There’s a lot of uncertainty in the macroeconomic environment.

John, opens the door up for you. From a buyer’s perspective, what are you hearing from buyers? What’s your approach with them? You also have to balance earnouts too against do they want to get a deal done? Where’s the tipping point from a seller where they say, “This isn’t worth it?”

In a 2019 deal study that I looked at, when you took out life science company deals, 20% of reported deals had an earnout component in it. The median earnout potential as a percentage of those deals was about 41%. Earnouts were a significant thing as far as the percentage of the price when they did appear, but appearing maybe 1 out of 5 deals. From what I’m seeing for my strategic buyers who are doing serial acquisitions, from what I’m hearing from people like you, Domenic, in the market, earnouts are going to be coming back. They’re going to get much more popular, both as a result of bridging valuation gaps, taking care of some of the uncertainties that either a buyer or a seller might have.

Another benefit for us as the buyer is that earnout money is money that’s sitting in our bank account. It’s the golden rule. He who controls the gold makes the rules. It’s a lot easier for us to make an indemnity claim and either contractually offset or non-contractually offset against that earnout amount when that cash is in our bank account. The last thing, and this isn’t quite as helpful in that most of your credit facilities are going to contemplate and require consent for earnout payments or other contingent payments. It’s a nice thing for the buyer to not have to come up with 100% of the theoretical purchase price at the time of closing.

Where do you counsel your clients, from a buyer’s perspective, as earnouts are probably going to be more prevalent, especially given COVID and the impact of businesses, but where is the stress point? Where have they pushed too far where now they introduce this earnout. It’s too much a piece of the purchase price and the sellers decide, “I’m going to hold on to the business or I’m going to go back out to market.”

It’s a fine line in that the sellers want that walkaway cash. The sellers are always thinking about, in a worst-case scenario, if anything goes wrong after closing, how much money am I going to have? When you start to put things either from the indemnities like we spoke about on our last episode or here with contention payments that aren’t guaranteed money, you start to push up to that line where it doesn’t make sense for the seller.

Either they’re going to go back to the market or they’re going to say, “I’ve got a business that’s generating revenue. At least I know that for sure and I can go sell it at any time.” For buyers, we use it to bridge evaluation gaps. When we cannot get to an agreement on what a company is going to either continue to do or will do in the future, we go to a seller and we say, “Put your money where your mouth is. You’ve said this is going to happen. You shouldn’t have any concerns with this earnout.”

When we start to get more speculative and we start to try to use an earnout to protect the buyer on worries about retention of key customer accounts, for example, or maintaining the business rather than growing it, that’s where I see sellers balk. It’s a lot harder for a seller to object to the concept of an earnout when there truly is a bridge between the parties. The seller is promising all different changes, whatever happened last quarter was a blip and not willing to stand behind that with an earnout.

You’re making a great point. We’ve seen buyers come to the table with offers for earnouts assuming that they can keep key employees post-sale or lock up certain accounts. Sellers pushed back because they’re like, “These employees have been here for twenty years. They have non-solicits.” You’re over-reaching at this point in time.

When you’re getting into categories that aren’t within the company’s control or the seller’s control, a seller can talk very confidently about a key customer relationship or that a new relationship is going to get signed up shortly thereafter, especially if the seller paying on. That’s one thing. When you’ve got new management, new ownership, it’s hard to say what Sue or Jeff down the hall are planning to do as far as retirement, or maybe they don’t like to work for the new boss. When it’s the stuff that’s more in the buyer’s control, that’s a lot more difficult to stomach.

With all the uncertainty in the macroeconomic environment due to COVID-19, buyers are now looking toward an earnout. Click To Tweet

Jeff, John brought up where the funds are held, the earnout money, in an escrow account controlled by the buyer. What strategies do you deploy there from a seller’s perspective to try to change that dynamic if at all?

That’s something that we try to address upfront to get to it in the LOI if we can. It is an uphill battle because a lot of times what the buyer does is it’s saying we have an offset. We feel like if there has been some damage to the company, we’re not going to pay you the funds. That’s something we try to attack upfront. The best way to address that is to make it part of the indemnity cap and get that indemnity cap set at a reasonable level. Even if there is some set off right, that set off right is constrained. It’s certainly the seller’s preference that it’s not sitting there in an escrow and they can decide to dole it out or not as they please.

Jeff, we brought up a little bit earlier that the devil’s in the details about how the earnout is written, what the rules are that everybody’s going to play by. Earnouts are fraught with potential liabilities down the road and lawsuits. What’s your approach there from a seller’s perspective? Let’s dive a little bit deeper on how can you protect yourself if you’re an owner when it comes to an earnout in that agreement.

The first thing we do is make sure that the calculation of the earnout and the benchmarks for it are clear. This always becomes an issue, Domenic I’m sure that you’ve run into in your business. You can spend a good 10, 15 hours on an LOI hammering out the terms, but it’s different doing that as opposed to spending tens to hundreds of hours in doing the actual deal flow. I find that we try to drill down on the terms upfront, but even doing that things can pop up when revenues are booked and how that’s going to impact an earnout. You have to be prepared, but you also have to be flexible going forward. That’s why it’s key to have a good business partner on the other side. I’ve found that even when we drill down upfront, there’s a give and take down the line. At the end of the day, you have to get to a very solid term that everybody’s on the same page where there’s no ambiguity to it.

There has to be trust in the deal. If there’s not a baseline of trust, you probably are going to string out that LOI negotiation and you might be opening yourself up for future issues. John, from your perspective, what would you add there?

I’d say that the buyer and the seller do have aligned interest in looking for clarity in the earnout. I’ve never represented a buyer that was eager to enter into post-closing litigation and certainly not during the transaction process. Having clarity of what people’s expectations is great because it takes that litigation risk off the table. Especially if you do have essentially a rollover seller, who’s going to continue on either as a minority owner or in some consulting or employment capacity. You want them to be able to achieve the earnout. It’s a payment that you’re happy to make. If you calculate the earnout right, you’ve made more money and they’ve made more money. It’s a win-win for everybody.

Getting that clarity there is where our interests are aligned. That said, we have some movement in the weeds looking at what is a net revenue definition? What do you net out? What is acceptable to take out? I’m buying a business. I need control of that business. Maybe we can talk a little bit more about whether or not the buyer has the right to remove a seller from their employment post-closing, but the buyer needs clarity in the earnout that post-closing they’re going to operate the business as they see fit. They’ll have no obligations to run the business for the purpose of achieving or maximizing any earnout.

Are those actual stipulations, drafting that you’d like to put into the definitive agreements?

As a buyer, I will have an acknowledgement whenever possible that the buyer has no obligations to operate the business or take or refrain from taking any action in a manner that’s designed to achieve or maximize an earnout.

Jeff, I’m sure sellers love to see that lineage.

Right after that, we put in, “They cannot take any action.” The intent of which is to decrease the earnout.

You got back to square one, to where we all started.

MAU 61 | Earnouts In M&A

Earnouts In M&A: From the buyer’s perspective, earnout money is money that’s sitting in their bank account.

 

We’re both going to be trusted business partners. John makes a very important point. There is an alignment of interests here. Sellers don’t want to be put at risk of not maximizing their proceeds, but you don’t want to be defensive too. There are opportunities here for sellers. It’s not one size fits all, but if you’re very bullish as a seller on your business going forward, and you say, “I can make more money doing a percentage of EBITDA growth because we’re going to grow in leaps and bounds.” There’s some element of risk there. If there’s competence about the business, you can use that to your advantage, to make more money than you otherwise would.

Just because a buyer proposes an earnout doesn’t mean you have to live with what they’re proposing. There’s no reason you can’t counter different metrics. They may be proposing EBITDA growth, but you might think that gross margin might be the better thing because you’ve got a new product that is going to hit the market. You’re going to have a competitive advantage. John, how do you feel about that when your client has proposed an earnout structure and then the sellers come back and said, “I don’t think those metrics are the right metrics. It’s these metrics that make more sense.”

It’s a personality trait, but I am always happy. I will pay you $1 every time as long as I get $1.10 return. If we’ve got the right metrics for measurement, that’s great. If we’re moving the needle on how rich that earnout is, the more that we’re paying to the seller, the less at the buyer and the company after closing are retaining. I tend to be more generous with earnouts in my philosophy, at least in that we’ve got interests align, and we can find somewhere where it’s a home run for both parties.

To your comments, kudos to you. You can tell your dealmakers. Jeff, you’re thinking outside the box. John, you’ve got the right perspective. Let’s assess this and see if it makes sense for all the parties. I think you guys that get deals done. You’re not digging your heels in. This is going to be a tough question because in our several decades of doing deals, I’ve never seen two earnouts that look the same ever. Are there some guidelines that you think buyers and sellers should be thinking about in terms of percentages of the overall purchase price timeframes for a payback? This is probably a tough question because it could be all over the map. There were guardrails to follow. What do you think those are?

One of the deal surveys in front of me, the last several years we’ve seen percentages go as low as 30% in 2018 and up to 41% now. There’s a lot of movement in those percentages. As far as the timeline goes, this can become a point where the seller and buyer are aligned, if not perfectly. The seller wants that earnout period figured out sooner than later. The buyer, the longer we can hold on to that money, the better. At some point, we don’t want that contingent liability on our books indefinitely. We want to know you either made it or you didn’t. When you have something out there longer, it’s a lot harder to understand whether or not the earnout was achieved because of what the seller said was going to happen or what the seller did or because of some other changes that occurred with the company or its management.

Jeff, do you have a thought?

It’s not a one-size-fits-all, but I start to get the hives once the earnout is over a one-third. That’s from the seller’s perspective. You want to get as much up front as you can. It’s the same with timing. If it’s a year or two, pretty typical. Once you’re going over two years, if the seller wants to be there and thinks it’s a longer road, that’s fine. After two years, I’d want them almost to become more of a typical employee, an employee that gets a very nice bonus. I don’t want to stretch out that earnout period too long.

You can’t be too sure. I’ll play your role a little bit here, Jeff. If you’re a seller, you need that runway to achieve the earnout. You don’t want a customer growth will increase by 30% and you get the earnout, but you’ve only got six months to do it. You do want a reasonable amount of runway. If you’re getting a percentage of growth, the longer that you can have that and continue to dip into that, the better as well.

It’s a matter of what you can forecast if you’re very bullish on what’s coming up on the horizon for you. Both parties agree and it can be achieved in a year, great. A lot of times it’s a more complicated integration and you want to leave yourself that runway.

The point that I would like to make here to the M&A Unplugged community is you have to be careful with these guardrails because there’s no two earnouts that are like, every situation is different. I’m going to highlight this here. We had a deal a couple of years ago where 75% of the deal was in an earnout. This was a distressed business. There was somebody even interested in acquiring the business because the business was tanking.

A few years later, I learned that the seller got their full payout. The buyer turned the business around and the seller wound up with a full payout. If you look at the other end of the spectrum, we put a deal under LOI where the seller got over asking price and they got an earnout on top of it for future growth. The buyer came to the table. They’re excited about the business. They threw an earnout on top of the deal as an extra incentive. You could use it in lots of different ways. There are two examples at different ends of the spectrum and everything in between.

John and I were talking about this before. It’s an interesting dynamic because you have a seller who knows their business, has preconceived ideas of what it’s worth, and has been used to running the show. That’s an interesting dynamic to then after the sale you’re working for the buyer, you don’t run the show anymore. It’s to our point earlier, Domenic, you got to have trust on both sides. You have to have a certain amount of flexibility on both sides too. I say that for the seller as well, you’re not going to be captain of the ship anymore. If you have a good counterparty, you can make it a win-win.

Both buyer and seller have aligned interests in looking for clarity in the earnout. Click To Tweet

This is such an important timely topic because, John, as you pointed out, 20% of all deals included in some form of an earnout. In this post-COVID environment, that percentage is going up. Who knows where it’s going to land? It’s only going up. It’s not going down. Buyers and sellers need to get their heads wrapped around this concept.

We were talking a little bit about escrowing an earnout amount. As a buyer, my starting point is to not escrow those funds because they’re not necessarily funds that are going to be paid. They haven’t been earned yet. I’ll come up with that money down the road. As cash becomes tighter, that can be something that can be helpful to buyers as well, to not have to come up with all of that money at the closing. To have to come out with that later in, theoretically, you’re paying out of the profitability of the business that you acquired.

The bank covenants would, in some cases, prohibit that as well. The banks don’t want the buyer’s money to be tied up. That leads into another potential protection for seller, Domenic. If there’s a substantial earnout, we want that guaranteed. We want some covenant that it’s going to be paid, but there are a lot of times you’re sitting behind the banks on that. You’ve got to be subordinated on that covenant. That can be a tricky terrain to navigate sometimes.

Guys, have you ever been involved in a situation where an earnout flips to a secured promissory note? The earnouts has been earned and it flips to a secured note that then gets paid out or that the earnout is in the form of a contingent note. The contingent note can be forgiven if the metrics aren’t met. Is that something that you’ve done?

I’ve done it with a note before. Not where it flips, but at the outset that it’s contemplated as a contingent.

You get all the promissory note elements in there to your point, Jeff. You know there’s a guarantee.

That’s a lot easier than a parent guarantee. Our starting point is we’d prefer not to do that. If an earnout is going to be met, there’ll be cash at the company to pay for it saying don’t pay attention to the depth that we have, the leverage that we’re going to put up on top of it. Anybody else that’s going to come in line in front of you, but a good bridge when the alternative is rather than the acquisition entity having the obligation. We want the purchaser parent to have a guarantee of the obligations.

This has been a tremendous conversation. I appreciate all the input. We’ll wrap it up here. I want to give each of you an opportunity to put up a recap on Jeff, the seller side, and John from the buyer side.

On the seller side, this along with indemnity are the two areas where the most attention probably needs to be paid because it’s the highest element of risk in the sale. I keep harping on it, Domenic, but it’s true. I know you’ve seen it in your business. It’s finding the right partner and the right counterparty is going to alleviate a lot of the ails that come along in this territory. There’s an element of risk, but you shouldn’t go into it in a total defensive crouch. You as a seller should have competence in your business. Get the best terms for you, but also see where the opportunities are where you can turn it into a win.

I would echo those points and add to that, as a buyer, an earnout is a great way to get a deal done. It’s a great way to bridge the valuation gap. As you know, Domenic, it’s also a great way to differentiate yourself and maybe even add a sweetener onto the deal. In addition to the purchase price, you’ve got to make sure that you’ve got the calculation, the formula correct. You don’t want a dispute afterwards. You don’t want a surprise. You want to have clear expectations for all parties. Finally, the buyer does need the ability to manage and operate its business.

MAU 61 | Earnouts In M&A

Earnouts In M&A: You have to have a lot of trust and flexibility on both sides to make the deal a win-win.

 

Things aren’t working out with the seller. They need the ability to remove them from the situation without having a financial penalty or risk of it with respect to the earnout tied into that. Let the buyer go. Hopefully again, we’ll have a good partner that we trust that we’ve diligence, that we’re going to work together and have a mutual win for. If things do not work out, you do need that protection to continue to operate the business as you see fit.

 

John and Jeff, if people wanted to get in touch with you, how could they best reach you? John, why don’t you kick it off?

It’s [email protected].

Our Chicago office is (312) 583-7488, and our contact information is on our website, which LawOfficesJTP.com.

Guys, thanks again so much. I appreciate you being here. It’s a great content.

I hope you enjoyed this episode. If you enjoy our content, please remember to subscribe and review the show. I look forward to seeing you again on the next episode. Until then, please remember that scaling, acquiring or selling a business takes time preparation and the proper knowledge.

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About John Schreiner

MAU 61 | Earnouts In M&AJohn Schreiner (Perkins Coie LLP) focuses his practice on providing counsel to closely held established and emerging companies for their daily business needs. He also represents private and public companies in mergers and acquisitions, divestitures, private equity financings, corporate governance, commercial contracting and general business matters. John has a wide breadth of industry experience, with a particular focus on food and beverage manufacturers and distributors, outdoor industry retailers and manufacturers, providers of mobile and web-based services, and biotechnology and medical products and device companies. https://www.perkinscoie.com/en/professionals/john-p-schreiner.html

 

About Jeff Petersen

MAU 61 | Earnouts In M&AJeff Petersen is a corporate attorney specializing in representing clients in M&A transactions. He has assisted clients in the purchase and sale of businesses in a broad spectrum of industries, including manufacturing and distribution, professional and IT services, food and beverage, technology and healthcare. Jeff graduated with honors from Georgetown University law school and, prior to establishing his own firm eight year ago, was a partner with K&L Gates LLP, one of the largest law firms in the world. Jeff utilizes his big-firm background, as well as his experience working hand-in-hand with mid-sized and small businesses, to bring a high level of expertise to clients at reasonable cost and with great attention to their needs. For a list of representative transactions Jeff’s firm has successfully represented clients on, please see the attached link: http://lawofficesjtp.com/bio-5/

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