Divider
Divider

Allen Liebnick
Allen Liebnick

Earnouts Are Rarely Earned

Here's why.

June 2, 2011
by Allen Liebnick, CPA, CFF

Lately in many articles I have read on business sales, the term “earnout” has been cropping up. I know that earnouts are frequently used especially in privately-held middle-market companies, to bridge the gap between the buyer’s and seller’s valuations of the business. To get a better understanding of the applicability of earnouts in a sales/purchase arrangement, I met with Mark Wigder, attorney-at-law and partner with the Texas-based law firm Looper Reed & McGraw. Mr. Wigder is well versed in earnouts since his firm focuses on corporate and securities law, mergers and acquisitions, public offerings, private placements, financings, SEC compliance and corporate governance.

What Are Earnouts?

“Earnout is a contingent element of the sales and purchase price of a business and is determined by a business’ future performance against certain contractually defined criteria or benchmarks (such as Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA)) over a period of time after closing,” said Wigder. When a purchased business fails to achieve such targets within a certain time frame, the buyer is usually relieved of meeting the contingent payments and, in some cases, only required to pay a lesser amount.

What’s the Appeal to Buyers and Sellers?

“Earnouts help sellers realize full value for their business, particularly when the business does not have a long operational history, has an unproven product or has operations in a risky or new market with which a buyer may not be familiar,” pointed out Wigder. While earnouts allow sellers to have greater input over the management of the business post-closing, sellers may resist them because of complications in negotiations and how earnouts entails a specific way in which transaction documents need to be drafted because of which delays and higher transaction costs often occur.

On the flipside, earnouts can be seen as a form of seller financing that helps reduce the buyer’s necessary cash at closing. “An earnout can be an effective tool to motivate the sale since the seller has the option to continue to be involved in the business post-closing. A buyer typically has the upper hand in negotiating the terms of the earnout using U.S. Generally Accepted Accounting Principles (GAAP) as applied and in administrating the application thereby putting the burden on the seller to negotiate for all contingencies. That said, earnouts can restrict the ability of the buyer to move forward after post-closing since the seller may have input over the management of the business, which can be seen as unappealing to buyers.”

What to Consider?

Most earnouts last between one and three years, with usually one lump-sum payment at the end of earnouts with shorter periods. Earnouts with multi-year periods allow multiple-payment payables at various intervals.

Earnout payments can be a flat amount, a percentage of the earnout target or a multiple of the amount by which the business’ income/sales/profits percentage exceeds the earnout target. It can also be made in cash or buyer shares. Wigder noted that some earnouts include a buyout option for the buyer or accelerated rights for the seller.

Buyout options entitle buyers to pay a specified amount to satisfy any remaining earnout payment obligations. This is useful when they want to sell the business before the expiration of the earnout period because it allows them to negate any seller-negotiated covenants that can impede the sale of the business. Acceleration rights protect the seller from changes that can adversely affect the business’ ability to satisfy the earnout payments when they become due. Wigder pointed out that acceleration provisions generally require all earnout payments be immediately due in the case of certain events, such as:

  • A sale of the business;
  • Breach of the operational covenants by buyer;
  • Termination of certain key employees of the business;
  • Bankruptcy or insolvency of the buyer.

Other Provisions

Earnout provisions typically address post-closing accounting principles to be applied, the measurement of the performance of the business and the post-closing conduct of the business. These include:

  • A covenant to continue accounting for the business “in accordance with GAAP, consistently applied” with respect to the business’s historical accounting policies.
    • Accounting principles include revenue recognition policies, depreciation policies, inventory accounting (FIFO v. LIFO), cost accounting, excess and obsolescence reserves, warranty and product returns, retirement and welfare benefits, bad debt allowance and litigation, environmental and other contingencies.
  • Sometimes buyers insist on using GAAP consistent with buyer’s accounting principles.
  • What should/should not be included when measuring the business’ performance against earnout benchmarks, such as:
    • Cost of transactions, including interest expense, compensation of management of the seller, post-closing capital investments, goodwill amortization, intercompany overhead allocation, depreciation, discontinued operations and extraordinary items.

Are Earnouts Recorded in the Buyer’s Financial Statements Under FAS 141R?

“Historically, earnouts would only be recorded in the buyer’s financial statements if and when the conditions to payment had been satisfied,” said Wigder. Under FAS 141R (new ASC 805), buyers are required to value and record an earnout and estimate its fair market value at the time of closing. “The recorded fair value is then subject to periodic adjustment based on the likelihood of payment as it develops during the earnout period. Likewise, when the final earnout payment is determined, the amounts reflected in the financial statements should be adjusted to the actual current period. Since this new accounting treatment will effectually accelerate the recording of liabilities related to the earnout, a buyer should consult with its accountants to determine such effect of the earnout,” he added. Corporate Finance Insider readers should note that these statements are true if the contingent consideration was initially classified as an asset or liability.  But contingent consideration is not subsequently adjusted if it was initially classified as equity in accordance with SFAS 150.

Conclusion

In a future column, earnout disputes including the applicable legal principles and recent earnout cases and how to avoid and mitigate these risks will be revealed.


Rate this article 5 (excellent) to 1 (poor). Send your responses here.

Allen M. Liebnick, CPA, CFF, is president of Overpaid Payables Recovery, Inc.. He has been providing accounts payable, sales tax and telecommunications post-audit recovery services for over 18 years. Liebnick is a member of the New York State Society of CPAs as well as Texas Society of Certified Public Accountants and chair of the 2011 Texas State Society of CPAs State Tax Conference. Liebnick thanks Mark Wigder for his contribution to this article.