Earnout Trends: Balancing Buyer And Seller Interests In 'Post-Closing Conduct Of The Business' Covenants

This is the first in a series of posts dealing with issues and trends in earnouts. In this initial installment, Warren Silversmith and Tania Djerrahian provide a general overview of the purposes and features of a typical earnout agreement, followed by a discussion of key issues arising in the negotiation of covenants relating to the post-closing conduct of the business.

Purposes and Features of an Earnout

An earnout can be an effective means of resolving differences between buyers and sellers with respect to the future prospects (and, by extension, present value) of the target business. Earnouts achieve this by making the ultimate purchase price partly contingent on actual future performance - in other words, by breaking the payment down into an up-front component and a post-closing payment or payments, the amounts of which (or in some cases the very existence of which) are tied to agreed performance milestones during a specified post-closing period.1 Where, for example, a business does not have a long track record, where it has significant potential for rapid growth, or where the vendor and purchaser cannot come to a meeting of the minds on purchase price, an earnout can bridge the valuation gap that often divides optimistic sellers from cautious buyers.

Because earnouts can give buyers and sellers the confidence to proceed with deals, they have become increasingly common. To be precise, studies indicate that earnouts are now included in roughly 20-25% of U.S. and Canadian transactions.2 However, as discussed below with respect to "post-closing conduct" issues - and in other contexts in subsequent posts in this series - earnouts create challenges as well as opportunities.

An earnout offers a practical and effective solution to a difficult problem. In order for an earnout to work, however, the negotiating parties need to reach agreement on a number of key points:

Duration: In Canada, earnout periods are most typically 1 to 3 years but not infrequently run as long as 5 years. Classic or reverse earnout: The parties may wish to consider a "reverse earnout", in which the vendor receives the maximum amount on closing, having agreed to make payments to the buyer in the event that subsequent performance milestones fail to be met. Because reverse earnouts are the topic of the second installment in this series, we will not discuss them further at this point. Type of payment: The payment may be a specified dollar amount or it may be a multiple or percentage calculated with reference to the target's performance relative to a performance milestone set out in the earnout. In the latter case, there may be a ceiling on the payment. Number of payments: The earnout payment can be a one-time payment or made through multiple payments. Performance criteria: The performance criteria on which the earnout will be based can be non-financial (e.g. obtaining a new contract or the launch of new product), but are more commonly financial (e.g. revenues, earnings, EBITDA or net earnings). Impact of certain events: The parties may want to address the impact of certain events on the earnout. For example, they may wish to agree in advance what happens to the earnout if the employment agreement with a seller who is to maintain an active role in management post-closing is terminated during the earnout period. Another matter that can be useful to settle in advance is whether an acceleration of earnout payments will occur upon a change of control of the earnout assets. Calculation of the performance criteria: Where the earnout is based on financial performance criteria, parties may reduce the likelihood of future disputes by specifying (i) the rules for the calculation of the financial metric, including the precise elements to be included or excluded from the definition of the metric; (ii) the person who will be responsible for preparing the financial statements with reference to which the earnout will be calculated; (iii) the principles upon which those statements will be prepared, and (iv) the allocation of the various elements that go into the calculation of the earnout if the...