DealLawyers.com Blog

November 12, 2021

Earnouts: An Overview

Houlihan Lokey has put together this presentation providing an overview of earnouts.  If you have a deal where an earnout might be on the table, it’s worth taking a look at and sharing with any client who isn’t familiar with the objectives, potential benefits & downside risks of an earnout provision.  Because I’m an earnout skeptic and this is my blog, here’s an excerpt addressing some of the potential downsides:

– A poorly crafted earn-out can result in mismanagement of the Business and can create contentious post deal disputes. As Vice Chancellor Laster of the Delaware Chancery Court (the “Court”) observed in Airborne Health:

“[A]n earn-out…typically reflects [a] disagreement over the value of the [B]usiness that is bridged when the [S]eller trades the certainty of less cash at closing for the prospect of more cash over time…But since value is frequently debatable and the causes of underperformance equally so, an earn earn-out often converts today’s disagreement over price into tomorrow’s litigation over the outcome.”

– The challenge in crafting an earn earn-out is to reconcile the parties’ competing priorities and their desire to shift as much post closing risk as possible to the other party.

– Buyers will want to (i) control the post closing activities of the Business and (ii) minimize the future earn earn-out payments.

– Sellers will want the Buyer to (i) actively pursue the growth of the Business and (ii) maximize the future earn earn-out payments.

– Structuring an earn earn-out usually involves complex accounting, valuation, and tax issues that require the involvement of expert ad visors.

– As it is impossible to anticipate and address every scenario that could impact the earn earn-out, there is usually a “trust me” aspect to the negotiation.

Other topics addressed include structuring an earnout, dispute resolution, valuation and tax considerations. The presentation also includes a section on contingent value rights.

John Jenkins