Exploring the impact of earnouts: a practical solution or dispute waiting to happen?

Wednesday March 16, 2022

In our latest Expert Q&A, Forensic Services Partner Henry Pocock explores the increased use of earnouts in transactions

One of the many outcomes of COVID-19 for the M&A market has been an increased use of deferred consideration mechanisms, including earnouts – otherwise understood as the mechanism that allows a buyer to pay part of the purchase price of a business to the vendor in the future.

Where buyers and sellers have remained keen to continue on and complete transactions, despite business performance being adversely impacted by COVID-19, an earnout is a practical solution to address the risk of over- or under-payment. On the one hand, buyers are concerned that the target won’t bounce back, so are often reluctant to pay a purchase price based on pre-pandemic performance, and on the other, sellers are concerned that the price they are being offered places undue weight on a temporary ‘shock’ that doesn’t reflect true underlying performance. Basing an element of the purchase price on post-completion performance helps bridge the valuation gap, and therefore makes sound commercial sense.

However, while earnout mechanisms represent a good way to hedge both parties’ risks, they can be difficult to negotiate and the propensity for post-deal disputes is high. The agreement of an earnout can easily be seen as nothing more than delaying the inevitable when it comes to the negotiation of the purchase price.

Typical earnout provisions in the sale and purchase agreement (SPA) will set out a process whereby the buyer prepares the earnout statement for review by the seller to an agreed timeline. The SPA will also set out ‘rules’ to be applied in preparation of the earnout statement. These ‘rules’ will comprise accounting policies and principles, including specific inclusions or exclusions from the calculation. If the parties cannot agree on the outcome, the SPA will set out a dispute resolution process which ends in expert determination, if mutual agreement cannot be reached.

As transactions agreed during the height of the pandemic move through the earnout period, buyers and sellers should look to measure achievement of the earnout, set expectations as to the likely outturn and to take actions to avoid any future dispute. Such actions will need to take account for the continuing impact of COVID-19 on the target business.

What should buyers and sellers be thinking about?

Much will depend on whether the sellers remain active in the business and are exercising day to day control, but key questions buyers and sellers should be thinking about are:

Is the mechanism clearly understood?

Understanding what variables are being measured to calculate the earnout and over what period – such as adjusted EBITDA, revenue and operating cashflow – is a vital first step. Disputes can arise from something as simple as a failure to retain consistent information, an issue that can arise following a merger of accounting systems, and a consequent loss of audit trail.

Understanding how the impact of COVID-19 is to be factored into any calculations is also important. For example, are particular items of income or expenditure, such as government support payments, to be excluded or normalised? A clear view of the mechanism enables each party to understand how it might be gamed and to ask the right questions when it comes to preparation and review of the calculations.

How is the business performing?

Proactive monitoring of financial performance in the earnout period helps to set expectations as to where the earnout is likely to land. While care should be taken in providing interim updates to the other party, it may be beneficial to provide context to the performance of the business in the earnout period to avoid difficult surprises arising. Added to this, it is almost inevitable that events will take place in the earnout period that were not contemplated when the mechanism was drafted. Identifying such matters and obtaining advice as to how they should be treated in the calculation will help the buyer when it comes to prepare the earnout statement and present this to the seller.

Are the conduct of business covenants being complied with?

Typically, the buyer and seller will have agreed a series of covenants governing the conduct of business in the earnout period. The purpose of these covenants will be to protect the seller from the buyer taking actions designed to reduce any earnout payment, such as diverting revenue or increasing costs, but will also protect the buyer if the seller retains day-to-day control – by accelerating revenues or reducing costs, for example. The parties should consider whether actions taken in the light of the continuing pandemic, including actions taken in good faith to mitigate the impact of COVID-19, are consistent with the covenants. To the extent an action taken in the best interests of the target business may fall foul of the covenants, the parties should proactively seek permission and, if necessary, agree amendments to the earnout terms.

What evidence is available?

Preserving evidence of performance, actions taken, and decisions made in the earnout period is crucial to being able to calculate and support the earnout calculation. While this may not be the top priority while managing the integration of the target business and responding to the challenges posed by COVID-19, identifying and securing contemporaneous evidence will put the parties in a better position when it comes to preparing and reviewing the final calculation.

Is early engagement beneficial?

While superficially, the parties’ interests in the outcome of the earnout do diverge, fundamentally both buyer and seller have a vested interest in the success of the underlying business. Therefore, identifying and seeking to resolve any points of contention early on will make for a smoother process at the end.

As example of this in action, is that any recovery from COVID-19 may be slower than anticipated. One option in this instance may be to extend the earnout period – particularly if the sellers are able to remain in the business and are committed to its success.

Or if an action is being considered in response to COVID-19 that potentially breaches the conduct of business covenants, the parties should consider agreeing up-front the consequent impact on earnout benchmarks.

Actions to take

Parties who entered into transactions in the early stages of the pandemic and who agreed to base an element of the purchase price on post-transaction performance, should review the sale and purchase agreement to confirm the basis of the earnout, including time periods covered and covenants regarding the conduct of business.

Their next step should be to estimate the likely outturn and what proportion of the earnout will potentially become due.

An important part of this will be to identify and quantify the drivers of variance against pre-completion expectations, including any factors arising from actions taken post-completion in response to the COVID-19 pandemic. If such actions are identified, parties should consider whether they breach the conduct of business covenants in the sale and purchase agreement, and take steps to address any potential non-compliance.

Following this, they should determine a strategy for engaging with the counterparty, including considering whether it would be beneficial to amend the terms of the earnout in response to the impact of COVID-19.

The pandemic has seen an increased use of earnout mechanisms as a sensible way to bridge the value gap between seller and buyer, and many transactions were able to proceed on this basis. However, when the mechanism was negotiated, the impact of the pandemic was uncertain. Accordingly, it is likely that events will have occurred, and actions been taken, that were not contemplated but which materially impact on the earnout.

Buyers and sellers should therefore take stock of the target’s performance against the earnout metrics to set or manage expectations, to confirm compliance with contractual requirements and to consider whether any remedial actions are needed. Rather than wait until the expiry of the earnout period, parties should act now, proactively addressing any issues identified.

Engagement with accounting and legal advisers is highly recommended given the complexities involved. Establishing the current position, identifying issues and developing a strategy in response – which may include an amendment to the mechanism – will help align the parties’ interest and reduce the possibility of future dispute.

Related team

Henry Pocock

Henry Pocock

Henry Pocock

  • Partner
  • Forensic Services
  • Birmingham