Case Study: Calculating the Earnout

When parties negotiate the purchase and sale of a company, in order to bridge valuation gaps, the parties agree to an upfront purchase price plus an earnout, with the earn-out based on milestones such as revenues, earnings, regulatory approvals or other future events.  According to data available in Forsite™ M&A Deal Tool that contains thousands of deal data points,  30% of all merger agreements contain an earnout provision.  Earnout provisions are strongly concentrated in life sciences deals, with 67% of such deals including earnouts:

With potentially millions of dollars of additional consideration at stake, determination of whether a milestone has been achieved can be contentious.

Recently, a public company buyer acquired a private company for an up-front payment of cash plus a significant annual earnout based on the acquired company achieving a specified EBITDA during the two full calendar years following the acquisition.  The acquired company, as a subsidiary of the public company buyer, achieved substantial revenue growth, thanks in part to access to the buyer’s customer base and leverage of the buyer’s market reputation.  The revenue growth was more than sufficient for the acquired company to achieve the earnout based on the acquired company’s historic cost structure; however, the buyer calculated that the acquired company did not reach the EBITDA threshold, due in part to added costs allocated by the buyer to the acquired company.

As representative of the selling shareholders, Fortis stepped in to investigate and resolve the matter.  Fortis requested from the buyer detailed information regarding the costs allocated to the acquired company, its internal transfer pricing policies, how it charges other subsidiaries for services, and other accounting information supportive of the EBITDA calculation.  In reviewing the accounting records, it appeared that the buyer was “premium billing” the acquired company for certain services, equipment and intellectual property provided to the acquired company.

Fortis raised the issue with the buyer, who countered that the acquired company’s revenue growth was largely attributable to the buyer’s contribution of sales leads plus the parent’s “goodwill umbrella” under which the acquired company now operated.  Accordingly, the buyer argued that it deserved a premium on transfers of services and intellectual property to the acquired company to account for the buyer’s contributions to the success of the acquired company.  

Fortis was able to demonstrate to the buyer that the earnout provisions in the merger agreement provided that the EBITDA calculation was based on the acquired company’s pre-closing cost structure.  Under that analysis, any new costs or expenses imposed on the acquired company by the buyer had to be eliminated for purposes of calculating the EBITDA.  As revised, the acquired company achieved the necessary EBITDA to qualify for the earnout.  Following lengthy negotiations, buyer agreed to pay the earnout.

M&A transactions present a wide range of situations where post-closing issues can arise.  As a leading post-closing shareholder representative on private M&A transactions, we have faced these issues many times on behalf of selling shareholders, and can effectively deal with these issues through our experience and judgement.  Please contact us if you would like to discuss any post-closing matter in connection with M&A transactions.  

Also, please check out Fortis Advisors’ Forsite™ M&A Deal Tool, our reference tool for the M&A community to empower dealmakers with the data they need to understand “market,” negotiate better deals and follow emerging trends.  For additional insights into the data, along with practice tips on M&A transactions, please visit our “After Closing Series” and “Fortis Insights”.