There are times when the buyer and the seller have entirely different concepts of the valuation to be used for the acquisition, usually because the buyer is basing its valuation on the seller’s historical performance, while the seller is using a much higher forward-looking view of its prospective performance. The earnout is frequently used to bridge the valuation perception gap between the two parties. Under an earnout, the seller’s shareholders will be paid an additional amount by the buyer if it can achieve specific performance targets (usually the same ones it has already claimed it will achieve during the acquisition negotiations).
The earnout is also a useful tool for the buyer, because the seller’s management team has a strong incentive to grow the business for the next few years. In addition, the buyer can shift a portion of its purchase price into a future liability that can likely be paid from cash earned in the future by the seller. It is also useful for the seller’s shareholders, since it defers income taxes on the payment.
However, many earnouts also result in lawsuits, because the buyer merges the acquiree into another business unit, charges corporate overhead to it, or shifts key staff elsewhere in the company – all factors making it extremely difficult for the acquiree’s management team to still earn the additional payment, or even to determine what its performance has become. Even if there are no lawsuits, the acquiree’s management team may be so focused on achieving their earnout that they do not assist the rest of the buying entity with other matters, so that corporate-level goals are not reached. Also, if the earnout award is based strictly on the achievement of revenue, rather than profit, then the acquiree’s management team may pursue unprofitable sales in order to meet their earnout goals.
The problems with earnouts can be mitigated by continuing to track the acquiree’s performance separately in the financial statements, carefully defining the earnout calculation in the original acquisition document, requiring earnouts to be based solely on net income achieved, and by adding an additional layer of compensation that is based on working more closely with the rest of the buying company, such as commissions for cross-selling. Also, to keep the acquiree happy, do not institute a “cliff” goal, where no bonus is paid unless the entire target is reached. Instead, use a sliding scale, so that some bonus is paid even if only a portion of the performance target is achieved.
The Earnout