Earnout complications/LBO structure/moving parts

October 28, 2024

by a searcher from Harvard University in Texas, USA

I have a situation trying to structure an earnout, very complicated as it gets.
Ebitda target $2m-$3m
2-years earnout
≥90% hits 100% earnout
≤70% hits 10% earnout
Earnout goal: 3.5x incremental ebitda as new purchase price (current ebitda is $2m but he claims it will be $3m).

Here are my questions:
Earnout gets paid after 2 years, then where is the cash landing in for 2 years?

What if he does not meet target on year 1 and meets target on year 2. Does that mean I need to pay him full 100% earnout valuation for meeting target just 1 year? Am I not supposed to base it on 2 consecutive years of performance? Alternatively what happens if he reaches 50% target on year 1 and 90% target on year 2. In that case - how do I assess the final ebitda since ebitda of these 2 years he hits different targets thus ebitda is a moving part?

Do you pay earnout each year or cumulative 2 years? If you pay the 2nd year, with no targets met on year 1 but target 100% met on year 2, and I end up paying him full earnout, what if suddenly after he gets earnout paid the customer leaves/ebitda drops again? Do you base year 1 ebitda as base ebitda, and then year 2 ebitda as the target ebitda met in year 1? Or do you fully give him 2 years to meet the target? What I mean is, is the ebitda target on a yearly basis or do I need to give full 2 years for him to achieve the Ebitda target? OR do I say you need to meet the Ebitda target each year separately to qualify for the 100% EO valuation at the end of year 2.

Does anyone have a sample earnout model/lbo that I can get hands on?
Thank you

Reply by a professional
from Dartmouth College in Los Angeles, CA, USA

The earnout is a purely contractual construction, meaning you can answer your above questions with whatever solution is workable for you and the seller, whether that's a 2 year average of EBITDA over 12 month periods, or a year by year determination on whether target is hit (and separate payments). You don't HAVE to do it one way. It's highly dependent on the business. These are all the reasons why earnouts can become such disputed provisions. If you search for earnout provisions in publicly filed purchase agreements with the sec online you'll get plenty of examples.

Reply by a professional
from Villanova University in West Chester, PA, USA

Agree with ^redacted‌ above. This is something you work with your attorney to customize depending on the circumstances involved and what makes the most sense for the deal and the parties, and what they can agree upon. Nothing in the above is something too complicated or overly complex for a good M&A attorney.

+1 more reply.

Join the discussion