Business Law Institute Earnout agreements focus of program at BLI meeting Uncertain economic climate helps make earnouts attractive

By Mike Scott

Legal News

In the current challenging economic environment, area lawyers agree that earnout agreements can make the difference in finalizing an acquisition during a time when business values are unsettled.

An earnout agreement can be used when there is a gap between an owner and a potential purchaser in the perceived value of a business, according to Zan Nicolli and Jeffrey Van Winkle, a pair of Detroit area attorneys who will be featured during an upcoming program sponsored by the Business Law Institute.

Both Nicolli and Van Winkle will speak about trends in the use of earnout agreements and possible pitfalls that lawyers should be aware about as part of the second day of the Business Law Institute (BLI), held May 21-22 in Grand Rapids. The BLI is hosted by ICLE and the Business Law Section of the State Bar of Michigan (see for more information).

Such a gap is often caused by the perceived future growth opportunities of a company that both parties believe is likely. A lawyer often plays the role of getting their own client to set realistic expectations.

"It does make sense to use or consider earnout agreements during a time of economic decline," said Nicolli, a corporate attorney with Dickinson Wright in Bloomfield Hills.

Today's business environment is making it more difficult to conduct merger and acquisitions work. And coming up with a fair price may be the biggest challenge, Nicolli said. Using current financial performance as a benchmark for the value of a business may not be fair because the value is likely depressed, particularly for industries such as automotive and manufacturing that have been especially hard hit by the recession.

Sellers often believe that the company being sold has potential for significant value that will rise in the coming years. So for the seller there is little downside to using earnout agreements as the purchase price likely will be adjusted post-closing in many cases, Nicolli indicated.

But there also is value to the buyer for using an earnout agreement, Nicolli said. Buyers can use an earnout agreement to finance the purchase, particularly if they would not otherwise have enough equity to afford the entire purchase price.

"At times an earnout agreement can help buyers who need a transitional period," Nicolli said. "It gives an incentive to the seller to stay on board for the successful transition."

As a common feature of many mergers and acquisitions, an earnout stipulates that the original owners of a business are paid for the sale of their company, following which they are contractually obligated to stay with the company through a transition period. That gives the sellers a demonstrable effect on the company's future financial performance.

Achieving or exceeding a certain level of performance, the criteria for an earnout agreement are typically set over a period of several years. That could allow the original owners to earn a much larger profit from the sale.

In such a highly uncertain economic time, business owners are thinking of ways of tying transactions to 20 percent of a purchase price. It is being used in a wide variety of industries such as manufacturing and technology and as part of more merger and acquisition work such as buy/sell agreements.

Given the uncertainty and volatility on purchase price of businesses since the economic meltdown, the use of earnouts is likely to be higher than usual over the next few years, even though they have been around for decades, said Jeffrey Van Winkle, a member of the Business Practice Group for Clark Hill.

"We see earnouts getting discussed as part of most transactions," Van Winkle said. "They are used as a bridge for buyer and seller costs. It can help clients come to an agreement more quickly on purchase prices."

There are many risks and pitfalls that can be involved with earnouts, Van Winkle said. One is that the risk of deferring the decision on a purchase price, and the timing of a deal, can be significant. Earnouts offer an alternative option that could appeal to both parties.

"Clients are asking their lawyers about earnout agreements," Van Winkle said. "So the more informed lawyers are about the pitfalls of these agreements, the better the advice they can give."

There may even be instances when an earnout agreement is used as a negotiating tactic when purchasing a business that is working its way out of bankruptcy, Nicolli said. Buyers in this scenario can position themselves as a "high bidder" if they build in an earnout agreement, and it is possible they may not actually have to pay that full price in the future.

"It's something that you put on the table when a buyer and seller can't reach a price," she said. "You can facilitate a sale that might not ordinarily be possible."

Published: Mon, May 17, 2010