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Startup Central

Earnout Provisions: A Deep Dive for Startups

Promise Legal Staff

• 3 min read
Earnout Provisions: A Deep Dive for Startups

1. Definition and Purpose of Earnouts in Startup M&A

Earnout provisions are contractual mechanisms in mergers and acquisitions (M&A) that tie a portion of the purchase price to the future performance of the acquired company. For startups, earnouts help bridge valuation gaps between optimistic sellers and cautious buyers. By making part of the consideration contingent on meeting predefined targets, earnouts align incentives: sellers stay motivated post-close, and buyers reduce the risk of overpaying based on projections that may not materialize.

2. Typical Structure

2.1 Measurement Period

  • Commonly 12–36 months post-closing.
  • Structured in quarterly or annual tranches.

2.2 Performance Metrics

  • Revenue: Straightforward but may invite revenue recognition disputes.
  • EBITDA: Focus on profitability, with customary add-backs and normalization adjustments.
  • Milestones: Product launches, customer acquisitions, regulatory approvals.

3. Negotiation Points

  • Performance Targets: Define clear thresholds, avoiding ambiguous language. (WYN Legal)
  • Payment Caps: Maximum earnout to limit buyer risk and manage seller expectations.
  • Time Frames: Balance adequate performance measurement versus seller’s attention span.
  • Governance: Seller’s role in post-transaction management to influence outcomes.
  • Information Rights: Access to financials, forecasts, customer data for transparency.

4. Drafting Considerations

  • Formula Clarity: Spell out calculation steps, definitions and sample calculations. (~50% of disputes arise from formula ambiguities. Kroll)
  • Materiality Scrapes: Exclude petty fluctuations, avoiding unintended breaches. (Harvard Law)
  • EBITDA Adjustments: Specify permitted add-backs (e.g., one-time expenses, restructuring costs).
  • Definitions: Rigorously define key terms ("Normalized EBITDA", "Net Revenue").
  • Control Covenants: Limit buyer’s unilateral changes to strategy, budget or headcount.
  • Exit Triggers: Events (sale, IPO, bankruptcy) that accelerate or terminate earnout obligations.

5. Common Pitfalls

  • Misaligned Incentives: Sellers focus on metrics at expense of long-term health; buyers may deprioritize support. (~60% of earnouts dispute. Freshfields)
  • Measurement Disputes: Conflicting accounting interpretations afflict ~40% of deals. (Gerald Edelman)
  • Data Gating: Withholding or restricting access to underlying data (~30% incidence). (PwC)
  • Managerial Efforts: Sellers undervalued or sidelined, triggering up to 20% shortfall. (Thompson Coburn)

6. Valuation Methods

  • Multiple-Based Valuation: Tied to revenue or EBITDA multiples; common in midmarket. (Grant Thornton)
  • Incremental Analysis: Focuses on additional earnings attributable to specific actions.
  • Hurdle Rates: Minimum thresholds before earnout kicks in, improving target attainment.

7. Delaware Case Law Highlights

  • Auris Health/Alexion (Del. Ch. 2021): Court enforced a post-closing revenue earnout and underscored strict adherence to contract language.
  • Delaware Chancery Opinions: Recent decisions clarify use of extrinsic evidence, show courts favor unambiguous terms, and often award summary judgment if metrics are clear.

8. Dispute Resolution Mechanisms

  • Arbitration: Fast, confidential; parties can select industry experts.
  • Expert Determination: Single or panel of technical experts to interpret calculations.
  • Litigation: Pursued when disputes hinge on broader contract interpretation or duty-of-good-faith claims.
  • Include a tiered “dispute ladder”: direct negotiation → expert review → arbitration.

9. Accounting & Tax Considerations

  • ASC 805: Contingent consideration recognized at fair value on acquisition date and remeasured each period, driving earnings volatility. (Deloitte)
  • AICPA Practice Aid: Best practices for valuing contingent consideration. (Baker Tilly)
  • Tax Treatment: Earnouts are ordinary income to sellers when paid; careful purchase price allocation is essential for seller basis and buyer amortization.

10. Best Practices

  • Early Advisor Engagement: Involve legal, tax, and valuation specialists during initial term sheet discussions. (PKF O’Connor Davies)
  • Crystal-Clear Language: Avoid loose terms; include examples and calculation samples in the agreement.
  • Seller Protections: Cap on negative adjustments, carve-outs for indemnity claims, and “good faith” cooperation clauses.
  • Dispute Ladder: Specify negotiation, mediation, expert determination, then arbitration or litigation.
  • Regular Reporting: Quarterly financial statements, budget comparisons, and KPI dashboards during the earnout period.
  • Governance: Limited veto rights over major decisions that could skew performance.

11. Conclusion: Striking a Balance

Earnouts offer a powerful way to bridge valuation gaps, align post-closing incentives, and mitigate buyer risk. Yet, their success hinges on meticulous drafting, clear performance metrics, and robust dispute resolution paths. By balancing risk and reward, engaging advisors early, and drafting with precision, startups can harness earnout provisions to close deals confidently and drive long-term value creation.