Infotech and the Law

Earmarked for earnout: What you need to know

Greg Giammittorio

A surprising number of recent acquisitions involving government contractors have included earnout provisions. These are not for the faint of heart. In fact, some well-known companies and private equity firms view earnouts as the devil incarnate and will not use them.

Nevertheless, in the right circumstances they can be useful to bridge valuation gaps. Owners of middle-market companies considering a sale will at least want to familiarize themselves with some of the key issues.

An earnout provision means the buyer and seller agree that part of the price will be contingent on the post-closing performance of the company's business. For example, in addition to the consideration paid at closing, a buyer may agree to pay the seller a negotiated multiple of earnings before interest, taxes, depreciation and amortization (EBITDA) in excess of an agreed baseline for a period of time after the closing, perhaps two to three years.

The structure varies, and many issues need to be addressed if parties to an acquisition consider using an earnout. Here is my list of the top five things to consider.

Diverging interests: Earnouts can focus the attention of the target shareholders ? often part of the acquired business' management team ? on short-term results during the earnout period. Also, some control and accounting concerns discussed next can impede integration that would be in the acquirer's long-term interest.

What to measure: Buyers may want to measure net income, arguing it is the best indicator of the acquired business' success. But sellers will worry that buyers may allocate too much overhead to the acquired business or make capital expenditures that result in inordinate depreciation charges during the earnout period, thus diminishing net income. In addition ? especially with the new goodwill and intangible asset accounting rules ? sellers will be concerned about opportunistic write-downs that would distort net income. One possible solution is simplifying the earnout formula by moving higher up the income statement to EBITDA, gross profit or even revenue. It decreases the number of things to argue about during acquisition negotiations and reduces the likelihood of post-closing disputes.

Who has control: Buyers own the business after closing and typically insist on full control. Sellers have concerns about decisions such as appropriate head count, hiring and firing personnel, access to and the cost of capital, the cost and wisdom of business development and marketing efforts, and sales of assets outside the ordinary course of business. Earnouts typically involve negotiations regarding a baseline business plan. They result in a combination: The sellers have an increased role in decisions or adjustments to the earnout calculations if they disagree with decisions not contemplated by the agreed business plan. Certain actions, such as a sale of the whole acquired business or a change in control, will often accelerate potential earnout payments.

Tax and accounting issues: The earnout formula should be designed with appreciation of tax rules for installment method gain reporting and, if the acquisition will be a tax-free reorganization, must be crafted to satisfy requirements under all possible outcomes under the earnout formula. Parties need to negotiate in detail the accounting principles that will apply and provide for dispute resolution in case of disagreement over the calculations or the appropriateness of adjustments.

Transaction costs and timing: These added complexities often slow the pace of the transaction and cost more to complete. But remember: The objective is to bridge a valuation gap, not to cause the transaction to languish and ultimately fail over inability to reach terms on the earnout provisions.

Greg Giammittorio is a partner at the law firm of ShawPittman LLP and can be reached at greg.giammittorio@shawpittman.com.

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