Protect Your Earnout

The most common exit for early-stage companies is acquisition by another company.  Because early-stage companies by definition do not have a long history of revenue and earnings performance, it can be difficult for the buyer and seller to agree on valuation.  The seller will argue for a high valuation based on expected growth and prospects.  The buyer will argue for a low valuation based on multiples of revenue or earnings, even though such methodologies are more suitable for mature companies.

The valuation gap can be bridged with an earnout.  With an earnout, a portion of the acquisition consideration is contingent upon the performance of the assets following the acquisition.  For example, an acquisition agreement might provide for additional consideration equal to 20% of the revenue generated by the acquired company in the 12 months following the acquisition.

A challenge for the seller is to ensure that following the acquisition, the buyer, who has control of the assets, will operate the business in an effective manner to maximize the probability of achievement of the earnout.  The seller can try to achieve this through language in the acquisition agreement.  For example, the seller may ask the buyer to covenant:

• To maintain existing or greater levels of business.
• To preserve relationships with customers.
• To provide sufficient capital to the acquired business to permit performance at planned levels.
• To maintain existing levels (or hire to planned levels) of staffing.
• To keep named managers in specified roles.
• To price products and services consistent with past practices.

The recent Delaware Supreme Court case, Lazard Technology Partners, LLC v. Qinetiq North America Operations LLC,___A.3d ___, 2015 WL 1880153 (Del. Apr. 23, 2015), highlights the importance of the contract language.  In that case, the buyer’s sole operational covenant prohibited the buyer from “tak[ing] any action to divert or defer [revenue] with the intent of reducing or limiting the Earn-Out Payment.”  Id. at *1 (emphasis added).

The seller argued that any decision that the buyer knew would have the effect of reducing or limiting the Earn-Out Payment was prohibited by the contract.  However, the Delaware Supreme Court enforced the plain language of the contract, holding that the conduct was prohibited only if the buyer was motivated, at least in part, by a desire to reduce the Earn-Out Payment.

The lesson for sellers is to avoid earnouts unless coupled with strong contractual provisions designed to maximize the probability of achieving the earnout.