I’ll Pay You Tuesday for Your Company Today – The Earnout, Part 1

Whether you are negotiating an acquisition in Silicon Valley or Small Town, USA, a part of the purchase price is often deferred. I have discussed in prior blogs those portions of the purchase price that are held back to reduce the buyer’s risk of liabilities and issues with post-closing audits. In future blogs, I will discuss a common purchase price deferral that will pay the seller based on the performance of the business AFTER it is sold, often called a contingent purchase price, or an “earnout.”

An earnout serves two purposes. First, it can bridge a valuation gap that may exist between the buyer and the seller. In a sense, the buyer is saying “If your business is worth that much, prove it.” Second, the buyer uses an earnout to protect against risks arising out of everything from insufficient due diligence to difficulty in integrating operations, that the ultimate value will be less than the purchase price.

There are a number of advisors, in addition to a merger and acquisition attorney, that are critical to creating an accurate earnout. First among equals is a CPA. An experienced CPA should be brought in early and often to provide advice concerning the general nature of generally accepted accounting principles (“GAAP”), where interpretations can vary, and how the parties have recognized revenue and expense items and the extent to which they differ. The second is both the buyer’s and seller’s accounting departments. Managing an earnout requires specific knowledge of the accounting functions of the parties involved, and many disputes can be avoided by understanding each party’s processes and how they are to be managed through the earnout period.

In a typical earnout, the buyer and seller negotiate revenue and other operational goals, and schedule payments based on the satisfaction of these goals at the conclusion of a particular period, typically one or two years. This creates a number of challenges, and opportunities for expensive and time consuming litigation.

The first major issue is how the parties determine whether a goal is satisfied. Agreements will typically require that the parties use GAAP to determine any accounting related issues. Any accountant will tell you, however, that GAAP is more of an art than a science. In defining how GAAP will be used, the parties need to determine how GAAP will be interpreted. One approach is to say that GAAP will be interpreted consistent with how the seller has interpreted GAAP. A better, but more time consuming approach, is to use the interpretations that are used by the buyer, determine the variances from the seller’s policy, and define as specifically as possible the interpretations that will be used to determine the earnout. This determination should be part of an exhibit attached to the acquisition agreement.

Technology companies, particularly those working in the software or Internet areas, often have unique revenue recognition issues. The manner in which revenue is treated for these companies needs to be defined very precisely with the assistance of the seller’s CPA.

What if the buyer’s books are not GAAP? There are a couple of approaches. First, the earnout can be limited to performance goals that can be relatively less difficult to define and determine, such as specific gross revenue. Second, the books can be converted to GAAP as part of a post-closing audit. Even if this method is used, however, it will be important to find those areas, such as revenue recognition, that are critical to the final amount of the earnout and define how it will be interpreted. Third, and most important, send a large retainer to litigation counsel, because the failure to use an accepted accounting method, such as GAAP, can often lead to disputes.

In a future blog, I will discuss how to calculate earnout amounts.