Earnout Clause – A Seller’s perspective
In many transactions an earnout clause (the “Earnout”) can bridge a valuation gap between the Seller and the Buyer.
While an Earnout Clause is useful to get to a negotiated agreement, the Seller will want certainty as to how it will be calculated, how the business will be run once the Buyer takes control and how and when it will be paid.
In this newsletter, we suggest some key provisions to negotiate in the Letter of Intent, and in the subsequent binding agreements, as to how the business should be run during the Earnout period and which expenses might be excluded in calculating the EBITDA (if the Earnout is based on EBITDA targets). In addition, we’ll discuss a typical triggering mechanism to provide for the Earnout payment to be immediately due and payable if a defined event is triggered. You may also be interested in reading our earlier newsletter on Earnout Clauses.
Running the Business
As part of the Earnout clause, the Seller will want the Buyer to commit to certain modus operandi on how the business will be run after closing. Typical conditions can include:
- Retain operating shareholders in their current roles during the Earnout period.
- Ensure that operating shareholders have day-to-day operational control of the business, including control over personnel changes and marketing during the Earnout period.
- Ensure the Buyer will not increase the base or bonus compensation of employees, consultants or agents of the company in a manner different from the ordinary course of business.
- Prohibit the Buyer and its affiliates from soliciting employees or customers away from the company.
- Maintain separate books and records and generate separate financial statements for the company in accordance with past practices.
- Continue to deal at arm’s length between the company and the Buyer or any affiliate of the Buyer on normal commercial terms such as would be appropriate between independent parties.
- Manage the company as a stand-alone legal entity and not make changes to the business that would materially affect its ability to achieve the targeted Earnout.
- Not co-mingle the operations and financials in any respect following any subsequent acquisition, amalgamation, merger or similar transaction, until the Earnout period is complete. Costs borne by the company related to such a transaction will be taken into consideration in calculating the Earnout EBITDA.
- Not allocate or charge any transaction expenses or other non-recurring expenses, overhead, or any management charges, directors’ fees or similar fees or charges, including but not limited to accounting, IT, treasury and audit fees that replace existing expenses in respective amounts that are greater than those currently incurred by the Seller.
- Divert revenue out of the company either directly or indirectly.
- Provide the support and resources reasonably required by the Seller in a timely manner to fund all reasonable costs relating to post-closing transition, integration and the corporate growth (including additional qualified personnel) reasonably required to maximize EBITDA.
- Provide adequate finance and working capital facilities sufficient to allow the company to continue to operate in the ordinary course of business from the closing to the end of the Earnout Period.
- Provide the company with the opportunity to fairly compete against other Buyer affiliates against potential customer opportunities.
- Not engage in conduct intended to, or which would be reasonably expected to, directly or indirectly hinder or prevent the maximization of EBITDA, including the sale of any material assets of the company.
- Not make any material changes to the company’s business model, marketing or pricing or relocate its employees or redirect their use.
Inclusions and Exclusions in calculating during Earnout period EBITDA
The parties need to consider how to treat the following expenses and should specify whether the some or all of the following expenses should be excluded; an earnout clause should consider the following:
- Allocation of revenues, costs and expenses between the company and the Buyer’s other businesses.
- Expenses outside the ordinary course of business.
- Revenues, costs and expenses resulting from additional acquisitions, corporate or operational restructuring, joint ventures or strategic alliances.
- Management fees to the Buyer or any affiliates.
- Revenue costs and expenses from any new lines of business that the company launches during the Earnout Period.
- Expenses related to the Buyer’s acquisition of the company.
- Costs and expenses associated with changes to any employee compensation inconsistent with historical practices of the company.
- Integration costs and one-time costs imposed by the Buyer during the Earnout period that are outside the ordinary course of business including, for example, updating IT systems or incurring new material capital expenditures.
- Debt costs that did not exist prior to closing or from any financing outside the ordinary course of business.
- Tax issues relating to the new owner’s size or foreign ownership.
- Any other non-recurring expenses that need to be excluded.
Triggering Events for acceleration of Earnout payment
The Earnout payment should be accelerated and immediately due and payable on the occurrence on any of the events below:
- A change of control, bankruptcy or insolvency of the company or its shareholders.
- Sale of the company or its business or a substantial number of its assets.
- Breach of the covenants and agreement set out above (i.e., outlined in the Running the Business section above).
- Termination of operating shareholders from their roles.
It will be imperative to involve the Seller’s tax advisors so that the tax treatment of the earnout clause payment is considered a component of the purchase price and subject to more favourable tax treatment (i.e., a capital gain) rather than business income.
In the end, there are several elements that could lead to a disagreement between the Buyer and Seller on the calculation of the performance clause. The objective of the parties should be to anticipate the elements that a Buyer will want to recognize in the target’s books in order to avoid surprises when calculating the performance clause payment.
Contact any one of our team members to discuss the most common pitfalls we may have identified in our past transactions.
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