M&A: The pitfalls of earnout

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Earnout is commonly used to reconcile the differences between a seller’s expectation and a buyer’s willingness to pay the sum expected by the seller.

It a contractual mechanism whereby the buyer will pay additional payment beyond the initial purchase price to the seller if the target company achieves certain business performance metrics after completion of the sale and purchase.

Although useful, there are some potential pitfalls in the earnout mechanism to look out for:

1.   The parties need to agree on the intricate details of earnout provisions in the SPA. The SPA should clearly set out the target financial or performance metrics, payment terms, partly responsible for calculation of the earnout, accounting practices and principles to be used in the calculation of the earnout and dispute resolution mechanism. Therefore, negotiation of earnout provisions may be time consuming and prolong the negotiation between the parties.

2.   Ambiguity in the earnout provisions in the SPA may give rise to disputes between the seller and buyer.

3.   Integration of the target company with the buyer’s business may affect short term performance of the target company and the earnout payment.

4.   For a seller who wants to exit, the seller cannot have a clean break from the target company until the earnout has been paid or if there is any dispute, until the dispute is resolved.

5.   Conflict may arise if the buyer and seller disagree on how business should be run after completion of the sale and purchase. This may affect the performance of the business and the amount of the earnout.

6.   The parties will want to ensure that the other party does not do anything to artificially manipulate the performance of the business during the earnout period.

7.   The buyer will want to ensure that the seller does not take a short term strategy (that is not aligned with the long term strategy of the business) in order to meet the performance target and get the earnout payment.

8.   The seller may not be in control of the target company after completion of the sale and purchase, and will want to ensure that the buyer does not do anything which make it difficult for the seller to maximise the earnout payment.

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This post was first posted on Linkedin on 6 April 2023.

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