Earnouts: Part 3 - Negotiation

“Forget about any earnout payments. Just assume that you’ll never see a penny of that money.”

I got that advice from my board director when I was negotiating the price early in my exit.

He’d been around the block on many deals, and seen the earnouts go wrong more often than not.

You pop the champagne, anchored on the total price that you have sold the company for, and count on getting paid all of it... Then you end up with far less.

Why does that happen? The mechanics of earnouts are poorly understood, and sellers often agree to terms that stack the odds against them. This often becomes their biggest regret about selling their company.

In Part 1, we covered why and when they are used. Check that out here – Earnouts: Part 1 - Why and when?

And in Part 2, we jumped into the nuts and bolts: the details of how they work and the mechanics you can expect. Check that out here: Earnouts: Part 2 - Mechanics.

Here, we will discuss how earnouts are negotiated, and explore how you can get the best deal.

Finally in Part 4, we will uncover how they go wrong and how to avoid getting screwed.

As a reminder, an earnout is a structure used in M&A deals where some of the purchase price is held back, and only paid to the seller if the company hits targets after the deal. To get up to speed, you can head back to Part 1 and Part 2 to read more.

The context

If you buyer expect to include an earnout, they should say so in their first offer.

They will say “we can pay a total price of up to £12m, but only £9m will be paid upfront and we will pay up to another £3m you hit these performance conditions”.

If they don't mention any earnout component in their first offer – that's great. But it might be worth double-checking this with them. A sneaky buyer might try to hold this back, and sandbag you with it later.

The components

As you saw in Part 2, the earnout contains four moving parts:

• Value – the maximum amount you can get paid under the earnout
• Metrics – what you will measure to calculate the payment
• Targets – the targets you need to hit, the amount paid for hitting each of them and how this is calculated
• Timing – when you will get paid

When negotiating your earnout, you need to consider the whole package. You can't agree to a value for the earnout until you've agreed how aggressive the targets will be and the timeline for payment.

So you should force your buyer to put together the whole package they want to offer before you commit to accepting anything.

Different approaches

There are different ways to approach the earnout negotiation. This depends on your motivations for selling, how bullish you are on your forecasts and if you want to keep working within the business. We discussed this in more detail in Price is not the only factor when selling your company.

Think about what you want, and set your strategy accordingly.

Some sellers will try to minimise the earnout – pushing for a higher percentage upfront, a shorter timeline and lower targets. That's great, but you won't get much upside in return.

Others will lead into the earnout. They want to increase the maximum payment possible, adding ratchets to the calculation and increasing the size of the cap. In return, they are happy to wait longer or have more ambitious targets.

Here's one thing to keep front of mind, coming back to the advice I got from my board director. Assume that performance could dip and you won't get paid much (or anything at all) under the earnout... would you still do the deal?

Other factors to consider

There are a couple of other important issues which should factor into your negotiation strategy.

👉 Compounding

A longer earnout period obviously has more uncertainty and risk. But it also means that you have longer to wait before you get your hands on the money. For a long period, you could miss out on 3-5 years of compounding – that could add up to an extra 50% in total. And you have less time to spend the money too. Smart sellers might push for a shorter window of time as a result.

👉 Tax

The tax situation on earnouts is complex, and varies based on the jurisdiction. You should get your own advice of course, but in many cases:

(i) some tax is due in the year of completion, before you have actually received any money; and
(ii) it can be treated as income, so taxed at a higher rate than a capital gain.

In the UK for example, you also need to estimate (guess!) the value of your earnout payment at the time of completion of the deal, and pay tax on that amount. You do that in the tax filing for year the deal completes. That tax is then adjusted once the earnout is calculated and paid. Plus, if your earnout payment is contingent on you staying employed with the company (which is common) they might try to tax you on this as employment income.

So £1 of earnout may be worth far less than £1 upfront once the tax man has taken his share!

Re-trading on earnouts

Earnouts are often the first thing to get 're-traded' during the deal process.

That means when the buyer seeks to change the terms of the deal that were agreed in the Letter of Intent.

The most re-trade is the Price Chip (just straight cutting down the price), but another tactic is to push a larger proportion of the total deal value into the earnout, or to change the calculation to make the payments harder to achieve.

They might do this because of an issue uncovered in due diligence that makes them doubt your forecasts, so they want to you 'prove' the performance through the earnout before they will pay. Or, they're just trying and get a better deal.

This article on price chips has some tactics for how to overcome this which apply to earnouts too.

Control

Let's talk about control.

Whilst you are in the earnout period, you need some control over how the business is run and managed. You want freedom to set the strategy, allocate capital and choose who to hire.

But there's a tension. The buyer is the owner of the business, and you need to fit into the wider needs of their group.

This tension is the main cause of fall outs during the earnout period. We'll dive into this in Part 4.

But for now, think carefully about the main freedoms you want to protect during the earnout period. You should flag these early in the negotiations and push to include them in LOI.

These can be just as important as the earnout terms themselves.

Problem solving

Let's work through some common issues that arise during an earnout negotiation, and give you some tips for how to work through them

👉 The buyer wants a massive earnout

That is a common problem. The buyer wants to have the best of both worlds — own the business from today but only pay most of the price if it does well in the future.

The best antidote here is competitive tension, using the offer of another more willing bidder to push back. Read more here.

Here’s a good script to push back on this point specifically… “You are making me take all of the risk here, but you are not sharing enough of the upside. I only get properly paid if the business is very successful over the next three years. Why wouldn't I keep the business, bank those profits, and then sell it later for a much higher amount? If you want to take ownership today, you need to make it worth my while.”

👉 Targets are unrealistically high

The targets for the earnout should align with the forecasts that you have shared with the buyer. Push back if they are expecting you to exceed these to get paid the full earnout. Arguing that they will accelerate growth post-completion is great, but those strategies are famously hard to implement.

There’s a key lesson in here - when you are building out your forecasts, be careful of pushing the numbers too far… the buyer might call your bluff and force you to hit those numbers to get the earnout. We discuss that in: The Goldilocks Problem: How to get your forecasts 'just right’.

👉 Metrics are unclear

You need the metrics to be crystal clear, so you know exactly what you are tracking against and how the final calculations will be made.

Here are some tips:

• Make sure the definitions are clear. What is included or excluded in the EBITDA? What accounting rules are we using? How will accrued revenue be handled?
• In Part 2 we talked about agreeing adjustments up front. These set out any special items which will be added or removed from the numbers for earnout purposes.
• You should also push for an independent review or audit clause to resolve any discrepancies objectively.

This level of detail isn't necessary for the LOI, but you should ask you lawyers and advisors to drill deep here when drafting the full contracts.

👉 Calculation formula is confusing

These calculations can get very complex. As complexity increases, so does the risk that you and the buyer misunderstand each other. There may be good reasons for adding complexity, but in general you want this to be as simple as possible and only add bells and whistles where truly needed.

A good approach is to write down a list of outcomes for the metrics and run those through the formula to calculate how much you might get paid at each. Then share this with the buyer and ask them to confirm that they agree with the calculations. You might also include these examples in the legal drafting.

Lastly, you want clear procedures for resolving any disagreements regarding earnout calculations. This should be to take the dispute to an indepenant mediation or third-party review.

👉 The buyer wants me to stay employed to get my earnout

This means that if you leave the business before the earnout ends, you're no longer eligible for any payment under the earnout.

This makes a lot of sellers angry – you're getting paid the earnout because you are a shareholder, so should be entitled to the payment regardless of your employment right?

But put yourself in their shoes. If a key reason for the earnout is to keep you motivated in the business, they need this clause to protect themselves. You could resign the day after the deal, and they would still have to pay you the earnout.

If you do agree to this, make sure the situations under which they can terminate your employment are very narrow – basically only for breaching the law. Otherwise they could use this to back out of a large payment just before the earnout period end.

👉 Protection for black swans

What happens if a black swan event happens during the earnout period that kills your chances of getting a payout? Who should take that risk?

You can try to push this risk onto buyer. You might not get it, but it's worth asking. To increase your chances, you should be very specific on which scenarios this would apply to, referring to particular events rather than general market issues.

For example, if you are in the hospitality sector you could refer to another Covid-style pandemic shutting down operations.

👉 The earnout period too long

This usually comes down to straight negotiation, rather than any specific tactics.

If you have uncertain future performance and sellers are key to performance, the buyer will push for a longer earnout period. That gives them a longer period where you have to prove the value of the business, and a longer period before they have to pay you.

And f your success is dependant on hitting longer-term strategic goals (like launching new products or entering new markets), the buyer will push for a longer period too.

You can argue that the period is unreasonably long, and that the health and sustainability of the business will be clear in a shorter period of time.

If the period is really important to you (because you know you want to move on or retire), you might trade that for slightly higher targets for example.