When the parties to the sale of a business are unable to agree on price, the buyer may attempt to bridge the valuation gap by offering to pay the seller an amount in addition to the purchase price – if the business is able to achieve certain earnings or other performance goals during a specified period of time following the closing of the sale. That additional amount is known as an “earnout.” Many sellers accept these offers, believing that the achievement of the goals on which the earnouts are conditioned is probable or even highly likely, based on the past performance and trends of their businesses. What these sellers may not realize, however, is that there are a number of other factors that make the achievement of earnout goals far from certain, and that the earnouts they have negotiated are gambles that may fail to result in any additional payment being made.
In deciding whether to accept a proposed earnout, we recommend that sellers keep the following considerations in mind:
- Once a buyer acquires a business, that buyer is generally not under a legal duty to take actions necessary to help the seller achieve payment of the earnout, much less maximize the amount paid, in the absence of a specific contractual obligation to do so (more on this in the second bullet point below). State law typically provides that a buyer has a fiduciary or implied duty to act fairly and in good faith in running the acquired business during the earnout period. However, this duty does not require the buyer to take any action that it does not believe will benefit the long-term value of its business in order to help a seller maximize the amount payable under an earnout, as the Delaware Supreme Court most recently held earlier this year in the case of Glidepath Ltd. v. Beumer Corp.
- A buyer may strongly resist adding language to a purchase agreement that obligates he or she to run the acquired business in any way other than what is believed to be in its best interest after the closing. (An exception could include an agreement not to take any action, or fail to take any action, with the specific intent to prevent or delay a business from achieving any of the earnings or other goals the parties agreed to as a condition to the payment of the earnout). This is because buyers want as much flexibility as possible to ensure the success of their newly acquired business, and do not want to take the risk of being hamstrung by restrictions in a purchase agreement that are designed to protect an earnout. As a result, they are usually unwilling to agree to broad protective provisions for earnouts.
- The sale of a business is inherently disruptive. Management is highly distracted by the sales process for a substantial period of time before the closing and the sale may involve significant changes in management. Additional challenges during the transaction could include a subsequent integration into a buyer’s existing business or mismanagement by the buyer after the closing. Such unpredictable elements can cause major changes in sales and customer service staffing, office closures and other cost cutting, and even sales of undesired portions of the acquired business. These factors often have an adverse effect on the sales, customer service and earnings of the business during the measurement period for the earnout, making it hard for the business to achieve the goals that seemed so reasonable to the seller prior to the sale.
At KJK, we have substantial experience advising clients regarding the sale of their businesses, and are well aware of the potential risks represented by earnouts. If you are negotiating the sale of your business and find that an earnout may be the only way to bridge a gap between you and the buyer on the amount of the purchase price, we urge you to consult with us first. Our team can help you assess the potential risks and, if possible, help you find ways to structure an earnout so that it becomes less of a gamble. If you have any questions, please reach out to Steve Bersticker at scb@kjk.com or 216.736.7219, or contact any of our Corporate or Private Equity professionals.
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