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This Sidley memo (pg. 2) discusses how the implications of the Covid-19 crisis may require buyers & sellers to scrutinize earnout provisions with a “new lens,” whether they are negotiating new deals or potentially renegotiating existing ones.  This excerpt addresses some of the considerations associated with using a “sliding scale” earnout instead of the more customary all or nothing arrangement:

Earnouts are often structured with all-or-nothing payment terms such that seller receives nothing if the earnout threshold is not met. It is difficult to forecast appropriate earnout benchmarks, and, when a company is performing well or creating value but these all-or-nothing terms are still unattainable, a seller (or former equity holders of seller who are current key employees of the target) may lose motivation to drive company performance.

Further, key employees of seller may terminate their employment with buyer in the absence of other significant retention mechanisms. Thus, when a company is performing well, but below an earnout threshold, value is lost when both parties would have continued to perform if a lower payout than was previously negotiated were available. In these scenarios, making a reduced earnout payment may be less costly to buyer than the loss of aligned incentives to drive future company performance or the loss of key employees. Similarly, if a threshold for performance is set too low, for example, because the longer-term impacts of COVID-19 are overestimated, seller may take its foot off the gas when it is clear that an earnout will be achieved, even if better performance is achievable.

Given the unexpected downturn in the economy caused by the COVID-19 pandemic, earnouts that were negotiated in 2018 and 2019 assuming in-line 2020 performance may be unachievable now and, without renegotiation, can result in value loss to both buyers and sellers. In some of these situations, buyer may still want seller’s ongoing assistance to navigate the current conditions and may be willing to pay an earnout, albeit in a lesser amount than originally negotiated, or amend the earnout metrics to incentivize continued assistance driving future value.

When earnouts are structured with a sliding scale payout (i.e., setting a floor for minimum performance and a ceiling for a maximum payment, with the payment based on a performance formula) or multiple payment thresholds (i.e., setting multiple payout levels in steps based on performance), this can help preserve some of the value that would have been lost in all-or-nothing payout structures.

The memo notes that if the buyer selects an appropriate floor and ceiling for its earnout obligations, a sliding scale or multiple payment structure may increase the likelihood that the parties’ objectives remain aligned.

– John Jenkins