Don’t Burn Out: Earn Out

When sellers and buyers of a private business are close to a deal but cannot agree on the purchase price for the target company, they often turn to earnouts. Simply put, earnouts are contractual provisions stipulating that a seller will receive additional compensation in the future if the target business meets certain performance metrics.

Earnout provisions can be helpful in two important ways: (i) to help bridge a valuation gap between the parties, and/or (ii) financially motivate sellers to remain with the business after closing and continue to drive successful results. In some instances, where the goodwill of the business is very closely tied to the seller, buyers can also use earnouts to hedge against a post-closing decrease in revenue resulting from the seller’s departure.

Earnouts are usually heavily negotiated between sellers and buyers. Key points include the length of the earnout period(s), the financial metric to be used (EBITDA, revenue, etc.) and the way such metrics will be calculated (including what costs and expenses will be included and/or excluded). Earnouts can take many forms, but four of the more common structures include:

• Traditional earnout

• Reverse earnout structures

• Tranche sales with a contingent purchase price

• The use of preferred share rights

We have included a brief description of each of these different structures below. The structure used in any given scenario typically depends on the most favourable tax treatment outcome for the seller while still allowing for the commercial deal negotiated by the parties to be implemented.

1. Traditional Earnout Structure. The traditional structure is the most common earnout structure used by sellers and buyers. In a traditional earnout, a certain portion of the purchase price is withheld at closing. The earnout amount only becomes payable if an agreed target (usually financial) is met or a specified event occurs post-closing. It can be paid in a single payment following the end of the earnout period or in multiple interim payments, depending on how many targets are set, and it is typically paid in cash or shares.

2. Reverse Earnout Structure. Reverse earnouts differ from traditional earnouts in that the buyer pays the entire purchase price on closing, including the so-called earnout amount. In this scenario, the earnout amount is usually paid in the form of an adjustable promissory note or held in escrow. In either case, it becomes due and payable to the seller upon the occurrence of a future event (i.e., achievement of an EBITDA or revenue target). If the target is not achieved, then the seller is obligated to refund all or a portion of the earnout amount to the buyer, therefore reducing the final purchase price.

3. Tranche Earnout Structure. Earnouts can also be structured through a multi-tranche sale where the shares or assets of the target company are acquired in portions and the purchase price for each tranche is contingent on the occurrence of a future event or based on a metric that is calculated in the future. For example, in a tranched share purchase where EBITDA is used as the metric, the purchase price may be calculated as a multiple of EBITDA, as at the applicable closing date, multiplied by the percentage of issued and outstanding shares being purchased. In this structure, since the EBITDA may be different at the closing of each tranche, the purchase price payable for each tranche of shares may also be different. This can be contrasted with a straight tranched sale of shares where there is no earnout, the purchase price for each tranche is known at the outset, and the only condition to the payment of the purchase price for each tranche is the passage of time.

4. Preferred Share Right Earnout Structure. Lastly, earnouts can be structured through preferred share rights, including through redemption or conversion rights (in the case of conversion, this is known as an earn-in). As with the other earnout structures, whether the shares convert or can be redeemed (and the percentage that convert or at what price they are redeemed) is contingent on the occurrence of a future event. While a redemption feature will eventually lead to a future cash inflow for the seller if the target is met and the shares are redeemed, a conversion feature is more commonly used to penalize a seller if the applicable target(s) are not met. This is usually accomplished by granting the buyer a right to convert non-voting shares into voting shares, thus increasing the buyer’s control over the target.

Your legal advisors can assist you with understanding different earnout structures and determining how best to utilize them in your transaction.   

For further information, please contact:

Arash Amouzgar         +1-604-631-4201
Michael Stevenson     +1-416-863-2458

or any member of our Private M&A group.