Common Pitfalls in Earnouts and Working Capital Provisions

Let’s say that as a business owner you find yourself in the fortunate position of being able to sell your company. As negotiations kick off with potential buyers, the terms “earnout” and “working capital” tend to be thrown around in every discussion. What do these terms mean and how might they impact the transaction? How can you ensure that the deal you’re making is the right one?

Earnouts

An earnout is a provision under which the seller will receive additional payments based on the outcome of future performance/events that are unknown when the transaction is agreed upon. While the upside of an earnout is more cash, there are also potential pitfalls.

A buyer will often seek to tie the earnout payments to EBITDA or to a revenue target. Sellers should be wary of EBITDA deals, since subsequent to the sale corporate expenses can be pushed down to the divisional level, causing EBITDA to plummet. In the case that the company is being merged into an existing company, the purchase agreement must be clear on how and who will get the credit.

If the earnout is tied to EBITDA, the seller needs to be aware of exactly what types of costs will be allocated to the company – you don’t want any surprises. Buyers should also keep in mind that once an earnout is agreed upon it will have to record a liability for the earnout.

Be very careful when negotiating earnouts to ensure that the terms are specifically laid out. There are typically a wide variety of variables in play and a seller needs to be aware of them all. The seller’s goal in this situation is to minimize assumptions being made by the buyer. This can be aided by maintaining accurate financials and developing projections that can easily be supported.

Earnouts are one of the most litigated areas after a transaction has occurred so both the buyer and seller have to be crystal clear how the earnout is going to be calculated. Earnouts based on the resigning of a major contract or signing a new contract with a specific customer are much less apt to be litigated than those that are based on EBITDA, earnings, or revenue.

Working Capital Provisions

Working capital is typically defined as the difference between current assets and liabilities. It seems like a simple definition, but when it comes to the sale of a business, it can be difficult for the buyer and seller to agree on the working capital target. The target is usually defined as the average working capital that it takes for the company to continue its normal operations and this number may vary if the company has peaks and valleys in its revenue.

It is critical for the seller and buyer to understand the agreement when it comes to working capital provisions. Know the definition of current assets and current liabilities and understand all predetermined adjustments and “exclusions.” During negotiations, both sides should have their legal counsel and accountant involved in reviewing the working capital provisions. In most cases, the seller will prepare a schedule of historical working capital and this is used to start the negotiations of what needs delivered to the buyer.

The methodology should be consistent with GAAP or some other objectively verifiable method of measurement and consistently applied. In the purchase agreement, we typically see that the seller delivers an estimated working capital calculation at closing, and the buyer has 90 days to review. After review, the buyer provides the seller with all known differences, and the seller typically has 30 days to respond. If they agree, the matter is settled and either money is due to or from the seller. If they don’t agree, a third party is retained to mediate the differences. Typically, the buyer will set up an escrow specifically for any differences in the calculation.

At the end of the day, it is critically important to ensure that neither party in the transaction is in the dark. Be sure you understand the agreement and how you want it to be structured, including working capital provisions. Be aware of the risks involving earnouts and that any associated contingencies are clearly defined and attainable from the seller’s perspective.

Thomas Yankanich can be reached at tyankanich@kmco.com or 215.441.4600.

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