Earnouts- A New Normal

Most of the transactions in the M&A space, are ending up having an earnout as one of the mechanisms to remunerate the promoters. Earnouts are paid in addition to the cash consideration paid upfront to the promoters/ selling shareholders at the time of closing. Whether it is due to trust (deficit) factor that the investor has on the promoters about the performance of the investee company or as a de-risking strategy or as a retention policy or for achievement of the milestones, whatever the reason may be, the investors are increasingly resorting to incentivising the promoters through earnouts. This is an effective tool to fill the gaps in the valuation of the company.

Earnouts are usually linked to various contingencies on the achievement of which they are settled. These are generally linked to achievement of agreed revenues or EBIDTA. While usually sellers prefer to have the top line as the triggering point, buyers desire this to be connected to EBIDTA. In certain transactions like involving pharma companies where development or commercialisation of the product takes longer, earnouts are also released phase–wise or on achievement of milestones. Further, defining the floor and a cap on the revenues/ EBIDTA is better for both parties.

As far as the timing of the earnouts is concerned, they are paid based on results with respect to a period(s) that are usually not longer than two years subsequent to closing.

Earnouts are paid to the selling promoters/ shareholders as long as they are continuing in the business. In case they are disassociated with the company, they should not ideally be paid. As a strategy, based on the negotiating power of the sellers, they should negotiate for the acceleration of this benefit in case of a forced exit (without any cause) at the instance of the investor. ??

If not properly documented, earnouts are going to be a major cause of concern between the parties and may lead to unnecessary disputes. Tax component adds another dimension for the whole model. Depending on the nature of the payment, it may be taxed either as a salary or capital gains. If not thought through well before the execution, tax component will dent the earnouts. Hence, adequate care must be taken while drafting the expectations between the parties.?