M&A Lawyers See Flood of Work From Tool That Delays Deal Payouts

M&A lawyers are grappling with increasingly complex deal-making processes as clients adopt a tool that lets buyers postpone paying the complete value of a transaction.

The challenge of finding a mutually agreed upon price is encouraging buyers to use the tool, known as an earnout, to pay the seller at a later date after certain milestones are hit. Lawyers have found use of the provision skyrocketing within the past five years.

“I’ve literally seen an earnout involved in every deal I’ve worked on in the last year,” said Liam Timoney, a private equity and mergers and acquisitions partner at Goodwin Procter. “If it’s not been ultimately featured, it’s still definitely been considered, and it’s been part of the negotiation.”

Earnouts are useful in a slow economic climate, when there is a large gap between what buyers expect to pay for a company and what sellers want to receive. The tool protects buyers from future risk because they can require certain benchmarks to be met, and it reduces their burden because they don’t have to pay the full value upfront.

There were $80.2 billion in deals with contingency payments last year, according to Bloomberg data. The volume and number of deals using earnouts in the past five years dwarfed the previous five, the data shows.

Earnout numbers have remained strong, despite a large dip in overall deal volume and deal count, which can be attributed to an unattractive economy for transactions. Deal volume last year dropped to $3.6 trillion, almost half of the highs of 2021 and the weakest period of deals in recent years.

Marissa Wiley, a partner at Nixon Peabody, said before the pandemic, about half the deals she worked on had earnouts. “But now I think nine out of ten deals I see—on an off-the-cuff estimation—have an earnout. It’s expected at this point.”

Earnouts reduce the speed of transactions and can increase the number of billable hours lawyers need to spend on the process. “It definitely slows things down,” Wiley said.

The time is spent defining milestones and creating calculations that all parties agree with. Lawyers also need to agree on what accounting practices the buyer will use.

Earnouts have been particularly popular in health and technology. Companies in those sectors often require early capital for research and development before there is a proof of concept to ease a buyer’s concerns.

Lawyers draft contingencies for such deals. For example, a buyer could promise to pay an earnout to a drug company if the product receives US Food and Drug Administration approval within a certain number of years.

For lawyers, that means ensuring that the buyer and seller are on the same page about how those metrics are counted. “There is a lot of negotiation,” Timoney said. “We work very closely with accountants to come up with that definition of revenue.”

Power to Buyers

Lawyers see some deals in which earnouts make up the majority of the total sale amount. Sellers have little choice but to trust that the buyer will make efforts to hit earnout-related milestones.

“If I’m a buyer, I’m not going to try and starve the business,” said Fried Frank partner Philip Richter. “Even if there’s an earnout, there’s a fair amount of money I paid upfront and no point in saying I’m not going to invest any more.”

Some lawyers advise sellers to calculate their bounty on the sale based on the check they receive before the earnout metric is reached, especially if the earnout is large.

“I tell my clients they should be happy with the money they are getting at closing, because maybe they never hit those metrics,” Wiley said. They should consider the earnout pay a “bonus” rather than a guaranteed payout, she said.

The prevalence of disputes is on the rise, shown by an increase in the number of dockets that mention both earnouts and mergers and acquisitions. Sellers have particular incentive to instigate a dispute if they do not receive an earnout they were expecting.

“They’re going to be looking for things to fight,” Wiley said.

Plus, the buyer and seller aren’t the only relevant parties in an M&A deal. Lenders play an important role in setting the guidelines for earnouts when they finance deals and may often determine the scope of an earnout from behind the curtain.

The lenders accomplish this by prioritizing themselves over other parties when collecting repayment from a debtor using a subordination agreement, limiting the size of earnouts or even blocking them in credit agreements.

“If things go wrong, many times, the lenders have required the seller and the company to include express subordination provisions,” said Lindsay Flora, a partner at Dechert. “Or often lenders require some form of dollar cap on the amount of earnouts that a company can pay during the course of a credit facility.”

There may also be instances in which either the buyer or seller breaches the earnout contract by failing to comply with requirements. For example, a buyer could have agreed to maintain a specific count of employees in the company and slipped beneath that threshold.

Even though disputes arise from these transactions, lawyers are yet to see a large surge in lawsuits from earnouts. “Litigation is not something that is usually incredibly productive for anybody, so people are able to work it out,” Richter said.