How Your Banker Can Help Maximize Your Earnout in a Sale Transaction / Part 2 of 2

In part two of this post, we describe the remaining four key elements of Navidar’s approach to earnouts, share additional lessons learned, and offer advice for helping sellers achieve their full negotiated earnout payments. You can find part one of this post here.

1. Select an M&A Banker Who Takes Earnout Negotiations Seriously. Your M&A banker’s mindset has an important impact on their effectiveness and ability to meet your goals. Our observation is that many bankers do not take the earnout provisions seriously in their negotiations with prospective buyers, in part because they do not believe that the earnout is likely to be achieved. Note, however, that this belief is a bit of a self-fulfilling prophecy, because if your bankers have created unrealistically high projections for future growth and financial success, then it is indeed unlikely that you will receive any earnout payments based on these inflated projections. This is yet another reason why taking a thoughtful and methodical approach to modeling your financial projections at the beginning of the sale process is well worth the effort.

Sell-side bankers often do not receive any compensation on the portion of the deal related to an earnout unless that earnout is actually paid by the buyer. Bankers also often believe that they have little impact on an earnout being achieved and, because they have negotiated them poorly in the past, their track record of receiving any future compensation on earnouts is poor.  So, the situation becomes a bit of a self-fulfilling prophecy. Clients do not want to pay at closing for contingent consideration and bankers have often done a poor job of structuring earnouts in the past. This combination of factors frequently encourages bankers to care only about maximizing deal consideration paid at closing. Therefore, it is critical to select a banker who has a good track record with earnouts and compensate them to some degree at closing for the value of the earnout.

2. Reject All-Or-Nothing Earnout Structures. An all-or-none earnout scenario basically means that a seller will get 100% of an earnout payment if they achieve the agreed-upon milestone, but receive nothing, that is 0%, if they do not achieve the full amount of the milestone. In an extreme example, if the seller’s sales fell $100 short of an agreed upon $10 million sales figure target in an all-or-nothing earnout structure, then the seller would receive no earnout payment at all. This clearly does not seem appropriate or fair and it does not create a healthy incentive structure for either party.

Navidar has avoided this pitfall in a number of our past sale transactions by creating earnout structures with ranges or sliding scales where our selling client would receive a percentage of the 100% target earnout payment based on the percentage of the target milestone that they achieve. In several transactions, we have been able to start participation in the earnout dollars if at least 75% of the target is achieved. However, the percentage of the earnout shared at that level is much more punitive than if 95% of the target was achieved. In another transaction, Navidar structured a make-up provision that provided our client the opportunity to receive make-up earnout payments in later time periods if they did not achieve the full earnout payments in the earlier time period. We have also structured earnouts whereby the target miss in Year 1 rolled over into Year 2 so that the seller could still earn 100% of the earnout pool.

Avoiding the all-or-nothing scenario has the added advantage of aligning buyer and seller objectives and does not create any incentives for the buyer to determine, for example, that the seller just narrowly failed to achieve an all-or-none earnout milestone in an attempt to relieve them from having to pay any contingent consideration.

3. Establish an Appropriate Time Period for the Earnout. Negotiating the appropriate earnout period is an important additional consideration. The conventional wisdom says to have the earnout period be as short as possible, and that makes sense in certain situations, but it may not be best approach in others. At times, we have discouraged sellers from immediately agreeing to an earnout with a 12-month duration simply because that is what the buyer proposed. We encourage sellers to think with their bankers about what time period would be most advantageous to them. For instance, in one of our sale transactions, we added an additional year to the buyer’s initial one-year timeframe and created a two-year term that allowed our client to receive additional make-up earnout payments that may have been missed in Year 1 of the earnout if its sales in Year 2 exceeded the agreed-upon Year 2 sales target. The buyer was happy to agree to this and it ultimately ended up benefiting our client.

4. Think Hard About How Things Will Work on a Day-To-Day Basis After the Deal Closes: Most sale transactions understandably focus on due diligence, negotiation, and closing, but we like to also spend time with our clients thinking in concrete terms about how things will work after the deal is signed.

We have provided a few examples below and some associated issues to consider:

a. Structuring Post-Closing Autonomy. It is important that sellers maintain some degree of autonomy after the deal closes. In some cases, the buyer will leave the seller with a great deal of autonomy and allow the seller to run the acquired company as a walled-off subsidiary during the earnout period. Other buyers will want to integrate the acquired company more fully into their business and operations. In the latter case, we try to structure the earnout in a way that maintains the seller’s autonomy over the key items, such as marketing spend or overall headcount, which will be most critical to enabling the seller to achieve the full earnout payments.

Key issues to consider include:

• How much autonomy will your company have within the buyer’s organization
• Will the seller be run separately or integrated fully into the buyer’s operations
• Who will the CEO of the seller report to in the new organization?
• Under what circumstances, if any, can a key manager of the selling company be fired by the buyer after the deal closes?

b. Memorializing Buyer Obligations Post-Closing. It is also useful to include language in the merger or acquisition agreement that describes what specific obligations the buyer will have to the seller after the deal is closed. A range of potential legal covenants, some of which are described below, can be applied to the earnout and documented in the merger or acquisition agreement.

Key questions to consider include:

• Will the buyer have to operate the business in good faith and fair dealing?
• Will the buyer be obligated to help the seller maximize the earnout payments?
• Would the full earnout payments be accelerated if there is a sale of the buyer to another company, or if the buyer’s business changes materially, or in the case of a material breach of the earnout covenants?

In summary, our clients’ experiences with earnout provisions in M&A sale transactions have been quite positive in many cases. In the right situations, earnouts are a valuable and useful tool to get sellers extra consideration and value beyond what was achieved at the closing of the deal. If done thoughtfully and skillfully, sellers can realize considerably more value than they would realize without the earnout structure. We encourage sellers to seek M&A bankers who understand earnouts and take them seriously, and who have the right toolkit and approach to maximize your chance of earning the most possible.

We hope that this two-part post provided useful insights. If you would like to discuss any of the advice provided above, or if you are currently seeking counsel on a potential M&A transaction, please contact Stephen Day at [email protected] or (512)765-6973.