How To Design Earnouts To Avoid Disputes

Dealmakers entering into an M&A transaction should understand how to design earnouts to avoid disputes. Including the earnout provision raises the chances of the deal closing with benefits for both parties. M&A advisors suggest using this strategy to cover the gap in company valuations.

Statistics show that at least 33% of M&A deals included an earnout provision in 2023. This is a surprising uptick from 21% during the same period in 2022. Several factors have contributed to this growing trend, and the most crucial is the reduction in the number of M&As.

Rising interest rates over the last couple of years have successfully curbed inflation. But, they have also resulted in an increase in the cost of borrowing.

Buyers looking to purchase companies are hesitant when raising funding because of the lower projected valuation of their target acquisitions.

On the sellers’ side, higher stock market valuations have raised expectations, and they demand a higher price for their companies. Earnout provisions allow the buyer and seller to reach a middle ground, making the deal attractive.

Read ahead to understand in detail what earnouts are and how to include them in the deal.

Understanding How Earnouts Work

Earnouts effectively bridge the gap between the company valuations from the buyer and seller perspectives. They act as an incentive to the seller to accept the offer and proceed with the closing. Buyers use earnouts as leverage to lower the risks when purchasing a possibly overpriced company.

However, considering that earnouts and their conditions are becoming more complex, the chances of disputes and disagreements is also higher. Here’s where the expert M&A advisor comes in. These professionals can help negotiate the terms, conditions, and provisions and draft the agreement.

A well-crafted agreement that includes fair and transparent earnout clauses reassures the seller, allowing the deal to progress without hurdles. Earnouts are essentially payments that buyers must make to the seller after the M&A transaction closes.

These payments are subject to certain conditions or the company achieving pre-determined financial targets or operational milestones. For instance:

• The team reaching specific research and development milestones
• Particular levels of production or production capacity
• Acquiring licenses and certifications or approvals from regulatory bodies
• Reaching milestones like Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA), .revenues, or profits

M&A advisors and legal teams on both sides of the table negotiate the provisions and terms. The terms and terminology are determined according to the circumstances under which the deal is taking place.

How to Design Earnouts to Avoid Disputes–Typical Covenants in a Merger Agreement

When drafting the M&A agreement, dealmakers must include clear and precise terms to indicate how earnouts will be calculated. Keep in mind that in case of a dispute, courts will not accept any implied terms. Only the covenants that both parties expressly agree to are accepted. For instance:

For Calculating Earnout Payments

• Conditions that the buyer must maximize the amount of earnouts they’ll pay.
• Convenant that the buyer will take the necessary actions and initiatives for the long-term growth of the company post-M&A. These actions may include commercializing and marketing new products, investing in asset purchases, and expanding its production capabilities. Essentially, any actions that can potentially raise profitability and earnouts for the seller.
• Both parties agree on a pre-determined schedule and rules for calculating the earnout amount. These criteria can be the EBITDA, number of new customers acquired, synergies, or discounts offered on larger orders. Such discounts encourage bringing in more customers for higher sales volumes.
• Both parties accept that a neutral, unbiased third party will calculate the earnout payments. However, the seller and buyer can present their feedback and arguments. While they can object to the calculation, it can only be on limited grounds, such as incorrect information used in the calculations.
• The agreement will include different possible scenarios and how the earnouts are calculated based on them.
• A covenant that allows the buyer to offset misrepresentations and damages against earnouts. M&A agreements must specify this possibility since courts may not accept the seller’s claim that the two are unrelated. Clear and precise language eliminates the possibility of conflict.
• Other documents not part of the M&A transaction should clearly indicate how to design earnouts to avoid disputes. The letters of intent (LOI), board presentations, term sheets, and other documents should consistently express the same criteria. Any ambiguous or nonaligned provisions can cause disagreements.
• Sellers can request to add certain covenants to accelerate earnout payments if the conditions are breached.
  

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For Company Management Post-M&A

• If the seller agrees to stay on as a consultant, the buyer cannot terminate their employment during the earnout interval.
• The buyer agrees to continue running the company in good faith, similar to the practices the seller has established in the past. These practices include accounting standards, mission, work ethics, culture, and customer service.
• Without this condition, the courts may accept any decisions the buyer makes regarding company management. When negotiating earnout terms, M&A advisors specify what they mean by “best efforts” or “commercially reasonable efforts.”
• Covenant that specifies whether the buyer can rebrand the company or its products and services.
• A covenant that allows the buyer to remove core talent, skill sets, and consultants or may any significant structural changes in the company. This condition will apply to any changes that can influence the earnout payment–whether maximizing it or interfering with achieving milestones.
• Buyers should be cautious about their conduct after the M&A deal closes. Any misconduct can raise questions about their compliance with the agreement’s terms and conditions.

Despite adding covenants and conditions to the M&A agreement, disputes and disagreements are real. Both parties may not agree on how the earnout payments are calculated. In that case, it’s advisable to negotiate a resolution or seek dispute resolution and arbitration.

Bringing in an independent accountant to deliver a binding judgment is never a good idea. That’s because they might need expert counsel to examine the facts of the dispute and determine whether the parties acted in good faith.

Benefits of Including Earnout Provisions in the Merger Agreement

Including earnout provisions can prove to be advantageous for both dealmakers in the M&A deal. If the company continues to perform well or performs above expectations, the seller can hope to get some returns.

From the buyer’s perspective, earnouts incentivize the seller and stakeholders to remain involved and committed to the company’s success. This factor helps the buyer hedge against unexpected events and derisk their investment against claims the seller might make.

Such events can include uncertain market conditions, regulatory changes, and other macroeconomic factors. For instance, the seller may project that the company has the potential to achieve a certain growth level. This can be equivalent to five times the earnings over the next three years.

The buyer can offer to pay a price that matches its current growth profile on agreement of an earnout. If the company delivers on its potential within the projected time frame, the seller can claim the price difference. Or, per the terms of the agreement, a pricing calculated on the actual growth.

Earnout conditions like these present a win-win situation for both parties. On the flip side, disputes have also increased four times over. Experts suggest that most dealmakers resolve their issues privately under the guidance of experts. This is why there may be a higher number of disputes than reported.

So, how to design earnouts to avoid disputes?

Designing Earnout Provisions–Avoiding Pitfalls

Avoiding disputes after an M&A transaction is possible by crafting the agreements meticulously. Here are some of the steps you can take.

Ensure You Use Clear and Precise Terms

You’ll retain the services of an expert M&A advisor and legal team when designing the agreement and other paperwork. The experts will ensure that they avoid terms that are open to interpretation. Terms and phrases can often be defined in subjective ways.

Instead, use metrics and numbers that can define the goals and milestones clearly. For instance, you can use net revenues, sales, EBITDA, getting licenses or regulatory approvals, and completing clinical trials. You can also further clarify metrics by mentioning the specific earnout that will accompany it.

Let’s assume that you’re using the net revenues metric. Your agreement will specify a percentage of the revenues and thus clearly demonstrate how the earnout will function. Adding deadlines for meeting the targets is also a practical move. For instance, clinical trials were completed within two years.

In addition to metrics, the agreement can also include rights for the seller. These can include the right to access information that can influence the earnout calculation. Sellers should be able to access the data buyers use to make strategic business decisions.

Most importantly, it is never advisable to use standardized earnout clauses and covenants. Each company and M&A transaction is unique, and dealmakers must design their earnouts after accounting for company-relevant aspects.

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Specify the Buyer’s Efforts and Obligations

When understanding how to design earnouts to avoid disputes, don’t make the mistake of assuming the buyer’s best conduct. Accordingly, the earnout provisions should specify that the buyer will make the best efforts and make sound business decisions.

Buyers should commit to running the acquisition to maximize its profitability and the earnouts for the seller. Interpreting best efforts and sound business decisions can be open to disagreement. This is why the merger agreement must include the definitions of the best efforts and conduct.

Some examples include industry-specific benchmarks to assess the buyer’s efforts. You can use terms like: “a party is required to do essentially everything in its power to fulfill its obligation.” Even so, there have been instances where buyers restrict the company’s performance to minimize earnouts.

This factor becomes particularly relevant when the earnouts are paid only within a specific time. Sellers can avoid this risk by including other provisions to prevent the buyer from firing core employees and continuing with ongoing training.

Or, sellers can insert clauses requiring the buyer to maintain promotional campaigns that have proven successful in the past. Here’s another example: binding the buyer to continue funding the research and development department for product improvement.

Assume Disputes Will Arise

When working out how to design earnouts to avoid disputes, assume that disagreements will happen. Accordingly, you’ll add covenants for resolving disputes quickly and economically without engaging in expensive court litigation.

The merger agreement can have clauses that outline the timeframe within which disputes must be resolved. For instance, set a 100-day deadline. Without these timelines, conflicts can extend for months and even impact company operations and stability.

Specifying the issues that can cause a dispute can also ensure that dealmakers resolve them quickly. Yet another covenant to include is how the dispute will be resolved. Define the specific subject matter experts to bring in, their duties, and if they can retain other consultants.

For instance, specify if the parties can resort to arbitration to resolve the matter. And, if both parties will agree to the solutions brought by the arbitrator. Defining who will have jurisdiction over the dispute is also a good move. An attorney should be assigned to deal with say, legal matters.

Again, if the dispute involves calculating earnouts based on revenues, an independent accountant could satisfactorily handle the issue.

To Wrap Up!

Although earnouts have several advantages in streamlining M&A transactions, working out their complexities can be challenging. Rely on expert professionals to guide you on how to design earnouts to avoid disputes.

Include the necessary provisions in the merger agreement to plan for disputes and conflicts. You’ll also include a framework for resolving the issues so both parties can reach a satisfactory conclusion.

Leverage this M&A strategy for the company’s long-term growth, profitability, and sustainability and ensure wins for all the stakeholders.

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