When in doubt, earnout
Friday March 09, 2018,
6 min Read
An earnout provision allows the promoter to reap the benefit of growth of the company that was sold. It is typically structured so as to compensate the promoter in the event the target company achieves the specified performance milestones during a specified period after the closing of the transaction.
An earnout is a typical promoter retention mechanism adopted in acquisitions. The startup industry generally saw many consolidations, and acquisitions will continue to be explored in the coming days for achieving growth, synergising businesses and expertise and for tapping into new market sectors. Acquisitions are also a common exit option for investors. However, promoters typically don’t get to “exit” in the same manner as investors. Given the crucial role played by promoters to drive the business and their familiarity with the company being acquired, buyers typically like to retain them for a short period post-closure of the acquisition, and stage their “exit” in a staggered manner. To make sure the promoter is compensated well for the efforts in transitioning, growing and integrating the acquired company/business, earnouts are offered and they indeed earn out through an earnout.
What is an earnout?
An ‘earnout’ provision allows the promoter to reap the benefit of growth of the company/business that was sold. It is typically structured so as to compensate the promoter in the event the target company achieves the specified performance milestones during a specified period after the closing of the transaction. This period is agreed upfront at the time of acquisition, and typically ranges from 1-4 years. Earnouts are especially important when structuring acquisitions of startup companies or companies tapping into new lines of products or technology, where one typically needs lead time before the efforts of the new business can actually fructify. Thus, earnouts become an excellent tool to bridge the valuation gaps arising as a result of the buyer’s skepticism towards the value of the business currently undertaken by the target company and the promoters’ positive perception of the value of the business.
How are earnouts structured?
An earnout is based on the target company’s achievement of certain performance milestones. These performance milestones could be either revenue based or non-revenue based, or a combination of both. EBITDA (earnings before interest, taxes, depreciation and amortisation), EBIT (earnings before interest and taxes), gross/net revenues, earning per share are typical examples of revenue-based milestones. Non-revenue based milestones are typically in the nature of completion of project or product, acquisition of a minimum number of customers, or obtaining a regulatory approval.
What’s in it for the buyers and the sellers?
Earnouts are a win-win, both for the promoters as well as the buyer. Through earnouts, a promoter can always negotiate payment at a higher multiple/purchase price. This way he can reap the full benefit of the business he grew and the efforts he puts in integrating the buyer and target company for good synergies. Earnouts also help prevent under-valuation, especially in the context of uncertainties on the growth of the business vertical, launch of new product etc., in the coming years.
From a buyer’s perspective, earnouts are equally beneficial given that it mitigates the risk of overpayment.
Moreover, the payment of the earnout amount by the buyer is postponed to a later date (and is subject to fulfillment of the prescribed milestones), thus giving it/him an opportunity to utilise the revenue of the target company to pay the earnout amount to the promoter.
What about the tax treatment?
There are mixed views on the tax treatment of earnouts. In certain jurisdictions like Delhi, the courts have considered the closing date/acquisition date to be the date of accrual of income for the purposes of taxation, even for earnouts that are in essence a future income. In other jurisdictions like Mumbai, the courts held the date of actual receipt of the earnout amount as the date of accrual of income, for the purposes of taxation of earnouts, as earnouts are, effectively, hypothetical income that may or may not be paid depending on various factors. Given the mixed views, it is important to negotiate the tax burden appropriately, while negotiating the deal documents.
Basic pitfalls to avoid
Even though earnouts are purely contractual, they have to be in compliance with the prevailing laws, especially when structured as a deferred consideration. Under the exchange control laws, if the shares of the (Indian) target company are being transferred between a resident and a non-resident, the consideration cannot be deferred for more than 1.5 years from the date of the execution of the agreement and the deferred consideration amount cannot be more than 25 percent of the total purchase price to be paid for acquiring the target company. Care must be taken to ensure that the structure does not fall foul of the regulations.
Similarly, it is equally important to opt for the right performance criteria basis which the earnouts are to be paid. There may be many external factors that play a role in deciding the growth of a business, outside of the efforts of a promoter. It would be unfair if the promoter, who has spent considerable dedicated efforts in the growth and transition of business during the earnout period, fails to receive the benefit of the same through earnouts solely on account of such external/extraneous factors. It is, therefore, important to identify these factors and suitably record the same in the deal documents.
Some useful tips for negotiation
It is important to discuss and negotiate the following arrangement, preferably at the term sheet stage:
- Who will control the target company during the earnout period (i.e. post the acquisition) - the buyer being the legal owner of the company or the promoters who have significant interest in the company’s performance?
- What kind of events will accelerate the payment of the earnout amount before the given time?
- Whether any kind of adjustments to the performance criteria can be made to take into account unusual changes in the target company?
- What kind of changes in the target company will not be permitted during the earnout period?
It is important to structure the earnout provisions well as any ambiguity in these provisions can not only result in a dispute between the parties, but can also have an adverse impact on the business of the target company and defeat/delay the bonafide party’s interests. Hence, it is equally important to engage the right counsel to advise you on the appropriate structuring and help you navigate through the negotiations smoothly, retaining the balance between the various conflicting interests.
(Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the views of YourStory.)