Fall - InsideOutdoor Magazine

Back Office
A Clean Exit
Understanding earnouts in a business transaction
by Phil Josephson
“If you don’t want to work you have
to work to earn enough money so that
you won’t have to work.” - Ogden Nash
An earnout agreement is useful
between a buyer and a seller of a
closely held business, particularly when
the seller and the buyer have different
views on the price of the business or
when used as a financing device to
consummate a transaction. An earnout
agreement is a portion of the selling
price which is made contingent upon
attainment of identified thresholds.
While useful, earnouts have downsides
and are inherent with litigation risk.
Drafting an earnout can be difficult,
especially when anticipating all possible
future scenarios. As a result, earnout
language may be ambiguous, and
those that do not draft adequately may
invite and encourage future litigation.
Loosely drafted earnouts may lead
to litigation issues such as implied
covenants to use reasonable efforts
to develop and promote the acquired
business, making representations that
buyer can make earnout payments,
revenues of another target acquired
during the earnout period applied to
the earnout, integration of the acquired
business as a trigger to an acceleration
of the earnout due to a merger, or
misrepresentations by the seller that
lead to skewed earnout payments.
Another issue arises when trying
to enforce an earnout. In such cases,
courts have had trouble proving or
calculating damages.
But earnouts do not need to be
invitations to litigation. Parties should
pay close attention to the accounting,
tax, securities, financial and non-financial
consequences of each aspect of the
earnout agreement. They should specify
in detail the nature of the threshold
42 | InsideOutdoor | Fall 2011
• Accounting
• Availability of Capital
• Management
• Change in Control
• Tax Impact
Structuring an Earnout
Issues for Consideration
• Earnout Amount
• Earnout Period
• Performance Goals
• Payment Schedule
• Operational Integration
giving rise to the earnout obligation, the sellers, since they will not be affected
methods that will be used in ascertaining by operating expenses or acquisitions.
whether Would the earnout your buying has been patterns achieved, change Buyers generally favor net income
the for inclusions large and brands exclusions that from you already thresholds stock on the ground that they are
the if earnout they calculation, decided and to who start will selling the direct best indicator of the target’s success.
determine to customers whether the on earnout their threshold Web siteWhen net income, EBIT or EBITDA are
had been met. Careful planning and used as the performance measures, the
Yes, I would stop buying
consideration of all from possible that Brand scenarios
11%
seller should ascertain what administrative
at the Yes, initial I would drafting buy as little will, as in possible the future, or general overhead expenses the buyer
from the brand
19%
minimize risk, avoid conflict and help will allocate to the target after closing and
Yes, I would reduce my buying
resolve any disputes. from that brand
determine 34% how those expense will impact
No, I would not change my buying
from that brand
13%
Earnout language may be
I am not sure
23%
Source: Shopatron
ambiguous and those that do
not draft adequately may invite
and encourage future litigation.
Outdoor Participation, 2006 to 2010
In the earnout agreement, the the post-closing figures.
identified thresholds used may be
Other areas for drafting consideration
Total Outdoor Outings
fixed or variable, and they may be nonfinancial
11.6 Billion or financial, 11.4 Billion or a 11.2
include whether the seller will require
combination Billion
of that the buyer adequately fund the target
all. Non-financial thresholds may include 10.1 Billion 10.1 Billion
during the earnout period so that it will
reaching certain Number milestones of Participants or achieving be able to capitalize on opportunities,
other identifiable 138.4 Billion goals.
or whether the seller will request a
137.8 Billion 137.9 Billion
Financial thresholds 135.9 also Billion
134.4 Billion
may vary provision that prevents the buyer from
in their composition. Revenue-based making subsequent acquisitions that
Participation Rate
thresholds are more attractive to
would affect the acquired business, or
49.1% 50.0% 48.6% 48.9% 48.6%