An Earnout Clause Measures Trust Not Just Price

The agreement had been signed that afternoon, and by eight the two sides were at a long table in the back room of a steakhouse with the glasses poured and the folder zipped shut in somebody's bag. The buyer's counsel raised his to the number on the signature page. Then he turned down the table, since Rosser Newton had said almost nothing all evening, and asked what I thought the back half of that number was worth.

I told him it was worth whatever the buyer had believed when he wrote the clause, which is a different question from the one the seller had been answering all week. The room laughed and moved on. I was not joking.

An earnout pays part of the price at the closing and the rest later, and only if the company produces agreed numbers over the next year or two. Every owner I meet reads that structure as a payment schedule. It is better read as an opinion.

What Does An Earnout Actually Pay For?

It pays for agreement. When a buyer and a seller cannot reach the same number for the same company, the deferred piece lets them sign anyway and settle the difference later with evidence instead of argument.

The textbook explanation is that an earnout exists to get a deal done when the two sides cannot agree on what the business is worth. That is true as far as it goes, and it is where most owners stop reading.

Say the price is $24 million. The buyer pays $18 million at the closing and the remaining $6 million only if the company clears a defined EBITDA in each of the next two years. Nothing about that is unusual, and nothing about it is neutral.

What the schedule has to settle is narrower than it sounds and harder than it reads. Who prepares the statement, on what accounting, by what date, and what the seller may do when he disagrees with the arithmetic. Those four answers are most of the clause, and they are usually drafted by whichever side brought the better lawyers.

The Strongest Case Against Reading It As Distrust

An experienced director would push back on me here, and he carries the better of the argument more often than I care to admit. His case runs like this. Two years out is not knowable by anybody, so a buyer who defers part of the price is pricing uncertainty rather than grading the seller.

Commodity prices move. A large customer can be bought by somebody who already owns crews. A field supervisor can resign in March and take the work out the door with him, and none of those are failures of the forecast.

There is a financing version of the same point, and it is the stronger half. A bank lends against what a company has already earned rather than against what it hopes to earn, so the cash a buyer can put on the table at the closing has a ceiling that has nothing to do with his opinion of anyone in the room. The deferred piece can be a constraint rather than a verdict.

I have sat on the buying side of this and made the same case in good faith. A board approving an acquisition has to answer for the cash it spends on the day it spends it, and deferring part of the price is the cheapest protection available against a year nobody at that table can see. That is a real reason, and it has nothing to do with whether the seller is honest.

The market data carries part of that argument too. In smaller deals the deferred piece is routinely a large share of the whole price, which is roughly what you would expect if the structure were simply how small companies get bought.

Why Does A Large Earnout Signal Doubt About A Forecast?

Because the size is the part the buyer chooses. A buyer who can price a company inside a narrow band pays most of it at the closing, and the share he pushes into the future is a fair measure of how much of the seller's forecast he declines to pay for today.

My position is plainer than the structure deserves and I hold it anyway. When a buyer insists that a third or more of the price ride on the earnout, he is saying in the only language that costs him money that he does not believe the forecast he just negotiated around.

The useful move is to ask him which line of that forecast he would not underwrite. In my experience he answers, and he answers specifically. It is one customer, one price assumption, or one man who runs the yard.

There are two questions I ask once the deferred share crosses a quarter of the price. The first is what the buyer would pay in cash today if the clause were struck out of the agreement entirely. The second is what he thinks the company earns in a bad year, because that is the number he is actually underwriting.

I have argued before that an investment memo is a scorecard you write in advance, and an earnout is the buyer's version of that document, with the difference that the seller has to sign it too.

The part that decides whether an earnout works is the definition of the measure and the written procedure for calculating it. A seller who negotiates hard on the maximum and leaves EBITDA to a two page schedule drafted by the other side has traded the part he could control for the part he cannot.

I have watched an owner lose most of a deferred payment to a reorganization that made ordinary commercial sense and happened to move three crews onto a different set of books. Nobody in that building set out to take anything from anybody. The schedule simply did not say what became of the measure once the business stopped being organized the way it was on the day of the closing.

A buyer pays cash for what he believes and writes a clause for what he does not.

Where Does This Reading Break Down?

It breaks where the uncertainty is real and shared. Some companies genuinely cannot be priced today, and there the clause is the only honest way for two reasonable people to write a number they can both sign.

The test I use now is whether a buyer can describe the uncertainty without describing the seller. A buyer who says the second yard may not fill, or the big contract may not renew, is pricing a fact about the world. A buyer who keeps circling back to how the numbers were put together is telling you something else, and he is entitled to say it out loud.

I have read distrust into a clause that was nothing of the kind. A buyer deferred almost half the price on a company I knew well, and I told the owner with more confidence than the facts carried that he was being insulted. The deferral turned out to be his lender's limit and not his view of the man across the table.

The owner held out for cash that was never coming, the process went sideways, and he sold eighteen months later into a weaker market. I was not the only reason. I was one of them, and I have been slower to make that call since.

The headline number is what a buyer is willing to say out loud. The clause underneath it is what he is willing to pay for, and those two have never been the same document. Rosser Newton will take that position in any room that wants the other side of it.

Photos by Caroline Attwood and Declan Sun on Unsplash

Sources

Information Challenges and the Use of Earnouts in Mergers and Acquisitions
M&A Earnouts, Risk Allocation, and Post Closing Incentive Conflicts
The Enduring Allure and Perennial Pitfalls of Earnouts