As the transactional markets have begun to defrost and M&A activity is picking back up to pre-shutdown pace, it is a good time to consider how deals are being structured in a COVID-19 world. A key structuring term used in the transaction community recently is the “earnout.” According to SRS Acquiom, 22 percent of all other-than-life sciences deals in 2019 had an earnout provision. This is a significant increase from 13 percent in 2018. It is widely anticipated that earnout provisions will be more widespread in 2020.

What is an earnout, and when are they used?

An earnout is a structure where some portion of the buyout price will be transferred to a seller only when the successful performance of an agreed upon metric, usually financial, is achieved. Earnouts are generally agreed upon when a buyer and seller share a vision and a culture but are apart on value. The earnout is offered to bridge the gap between valuation thinking of the parties. It is also a way for the seller to offer confidence to the buyer in its forecast. During the pandemic, SRS Acquiom reported that, on average, earnout periods are expected to extend from 12-18 months pre-pandemic to as long as 18-24 months or longer.

An example of an earnout is Company X selling for $20 million in total value – $15 million at closing with the balance of $5 million paid over the subsequent year upon achievement of agreed upon performance metrics. If the seller achieves the metrics of the forecast, it will receive the additional $5 million in consideration; if not, it may receive some or none depending on structure.

Where earnouts go bad

While an earnout can be used to achieve a meeting of the minds on value, there are pitfalls sellers should take into consideration. There is more litigation about earnouts than most other issues that surround closing a deal. Earnouts structured on bottom-line financial performance can be manipulated by the new owner after taking control by adding expenses to the overhead structure (e.g., management fees that a private equity buyer might impose) or other means such as starving the salesforce or not investing as articulated in the strategic vision of the forecast. Buyers have been creative in assuring themselves that no additional consideration will be paid after the initial cash commitment; good advisors will advise clients that if they need to achieve the earnout to meet the needs of their post-sale goals, they should very seriously consider refusal, which might mean delay.

In the past, financial performance-based earnouts have been generally structured utilizing the seller’s business forecast provided during the transactional process. Sellers are famously enthusiastic in their forecasts of the future to entice buyers to the table; GHJ always urge clients to be realistically hard-nosed in articulating the future. Missing forecasts during or after the process can have devastating consequences to an earnout.

How does COVID-19 factor into this?

In the new COVID-19 world, assembling a realistic forecast has become a challenging exercise. As an example of these challenges, for deals that closed before February this year, what will happen to an earnout based on the full 2020 year? Anecdotally, GHJ has heard about 2020 earnouts being extended to acknowledge the COVID impact on all business forecasts that were assembled prior to the impact of shutdowns. In this environment, current financial performance as well as future performance have been and will continue to be impacted by COVID-19 and the resulting shutdowns. Because of this, as difficult as earnouts were to negotiate pre-COVID-19, they will be even more challenging until things return to “normal.”

GHJ Insights

It is a best practice for sellers to articulate a range of forecasts based on realistic scenarios that might occur under a variety of sets of assumptions. Further, it is also best not to agree to a “cliff” earnout where achievement is all or nothing. Rather, if an earnout is required, a business and its advisors should negotiate a continuum of performance outcomes with different or ratable payments be made depending on where in the range of actual performance results are achieved.

GHJ has recently encountered a novel structure in that cash at closing is based upon recent (including COVID-19 2020) performance, with additional consideration to be paid based on the improvement to 2020’s performance during 2021. There is no “cliff,” but additional consideration will be paid (using the multiple paid at closing) to improvement of 2021 over 2020 results. GHJ likes this structure because it is all upside with no penalty for COVID-19; sellers that are confident in a 2021 recovery should advocate for this structure.

Finally, given the nature of the uncertainty in future results, GHJ is especially focused on financial goals that are either revenue or gross profit oriented, rather than using other metrics such as Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA).

Tax considerations for earnouts

As discussed, earnouts are now prominently featured in many private company transactions. Since the earnout is an element of the purchase price, and the consideration is deferred and contingent on a set of future events, the taxation of this arrangement can have unexpected results.

Is it a sale or is it compensation?

With capital gains tax rates currently lower than ordinary income, the holy grail of taxation is achieving capital gain treatment for gains on the sale of a business. Sellers of privately held companies consider tax treatment of a transaction as a major driver of entering into and completing a successful transaction. If the payment of the earnout is predicated on the target company’s future financial performance, the selling stakeholders may well end up with long-term capital gain tax treatment on the sale. Instead, if the payment of the earnout is contingent on selling shareholders performing services to the target company or otherwise refraining from competing in the future, government taxing authorities may well characterize a part or all of these types of contingent payments as compensation, thus re-characterizing the payments as ordinary income.

If the earnout is not tied to performance of future services, the overall transaction will more likely than not be an installment sale, achieving deferral and capital gain treatment.

If you have any questions on the above, GHJ’s COVID-19 Response Team has as an experienced team of consultants specializing in COVID-related laws and programs and can provide the tools your business needs to help it recover from this business disruption. We are here to assist organizations to succeed in these very challenging times.