An Update on Earnouts

New accounting rules may require that acquirers and acquiring companies report earnout agreements as liabilities.

Joel Johnson, president of Orchard Partners Inc., in his article, “Earnouts,” published by Valuation Strategies, states: “In a given year, 2% – 3% of announced mergers and acquisition agreements involve earnouts.  These figures probably understate their prevalence.  Earnouts tend to be a characteristic of smaller deals; and in many small deals, terms are not announced.  Earnouts are rare when public companies are acquired and more common when ownership is concentrated among a few shareholders.”

This would mean, if implemented, that earnout agreements must have a value placed on them for accounting purposes. As Joel Johnson points out, “The higher the earnout, the greater the liability.”

Why the Earnout?

Johnson further states that earnouts are used for various reasons:

1. to bridge the pricing gap between the seller who places a heavy emphasis on the company’s projections, and the buyer who places most of the company’s value on its present and past performance.
2. to tie the acquisition payout to future performance.
3. to create a form of seller financing in that some of the buyer’s purchase price is delayed into the future. 4. to establish a form of escrow account in that the money is paid on condition of meeting certain thresholds.
5. to act as a type of employment agreement in that the CEO has to stick around in order to collect.