In defense of earnouts

Matt Bartus —  February 2, 2010 — 2 Comments

Earnouts in M&A transactions are a hot button issue. Basically, an earnout is a way for the buyer of a business to pay money in the future if the business meets certain milestones. It allows buyers to “bridge the gap” between the seller’s and the buyer’s idea of the value. Earnouts get a lot of bad press because they often lead to disputes, hard feelings and sometimes litigation. And they can be notoriously difficult to negotiate due to the tension between the buyer wanting complete control over how it runs the business, and the seller wanting to retain some control to ensure that the value of the earnout is maximized.

However, let’s put something out there: for some startups, earnouts may be the only ticket to the big payday. Buyers value startups on metrics that may not yet exist at the startup. How do you value potential? Simple answer = not so easily. Earnouts permit the buyer and seller to agree to disagree on price based on one or more (hopefully clear) metrics. If the startup generates huge sales for the buyer, the startup’s shareholders will collect big time.

Earnouts have gotten some attention recently because of a recent case (Sonoran Scanners v. Perkinelmer) that found, under Massachusetts law, an implied obligation of the buyer to (and I’m paraphrasing) maximize the value of the earnout. Because of this case, buyers may find the need to expressly disclaim any obligation to meet this duty, which won’t look good in an acquisition agreement and will make earnouts harder to negotiate. It remains to be seen how this case is applied under California, New York or Delaware law where most of the M&A activity resides. However, it makes earnouts more attractive to sellers so don’t necessarily turn your back on them.

  • Nivi

    I’m glad you’re blogging Matt! How often do investors (especially VCs) participate in the earnout and why?

    • mattbartus

      Nivi, happy to be blogging! In my experience, the investors are nearly always participants in the earnout. The earnout is typically structured as pro rata based on ownership. It would be unusual for an investor to not be subject to the earnout, especially because it means up-front value needs to be taken away from some other stockholder to pay off the investor. So in tech deals, this is the norm. Thanks for your question.