When selling a business, the concept of an earnout is often used to bridge the gap between a seller’s expectations and the buyer’s valuation of the company. An earnout is a contractual provision in which a portion of the purchase price is contingent on the business achieving certain financial milestones after the transaction. One of the most common metrics used to determine earnout payments is EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). However, understanding how to negotiate the terms of this calculation is crucial for both buyers and sellers to ensure fairness and clarity.
Understanding Earnout EBITDA
EBITDA is a widely used financial metric because it reflects a company’s operating performance by focusing on earnings generated from core business activities. When it is used to calculate earnout payments, both parties typically agree on a specific EBITDA target over a set period following the transaction, which will determine whether the earnout triggers additional payments to the seller.
However, the definition of EBITDA can vary from deal to deal, and it is important to explicitly define the calculation methodology in the purchase agreement. This ensures both parties are on the same page and helps avoid disputes during the post-transaction period.
Key Terms to Negotiate in Earnout EBITDA
Several adjustments should be considered when negotiating the terms surrounding the calculation of EBITDA for an earnout. Buyers often want to minimize their earnout obligations, while sellers aim to maximize their potential earnout payments. Both parties must agree on certain key adjustments to ensure the calculation is fair and reflects the true financial performance of the business.
1. Monitoring Fees
Monitoring fees are often charged by private equity firms or other investors to cover the cost of overseeing the company post-acquisition. These fees should be excluded from the EBITDA calculation. Including them would unfairly reduce the earnings figure that the seller is working toward in order to trigger the earnout.
Example Clause: "Monitoring fees incurred by the buyer, or any affiliate thereof, after the closing of the transaction shall be excluded from the calculation of EBITDA for purposes of determining any earnout payment."
2. Strategy Fees
Strategy fees are another expense that should be excluded from the EBITDA calculation. These fees are typically incurred for services like business development or expansion strategy, which may not directly relate to the operational earnings of the business. If included, these fees could artificially lower EBITDA and reduce the amount owed to the seller.
Example Clause: "Any strategy fees, including those related to business development or consulting services, paid to the buyer or its affiliates post-closing shall not be included in the calculation of EBITDA for earnout purposes."
3. Transaction Insurance Expenses (Tail Coverage & RWI)
Transaction insurance, particularly tail coverage (which extends the buyer’s insurance coverage for the seller’s representations and warranties post-closing) and Representations and Warranties Insurance (RWI), are often used in M&A deals to mitigate risks. These costs can be significant, and they typically should not be factored into the earnout EBITDA calculation as they are one-time, non-recurring expenses that do not reflect the operational performance of the business.
Example Clause: "Costs associated with any transaction insurance, including tail coverage and representations and warranties insurance (RWI), shall be excluded from the EBITDA calculation for purposes of the earnout."
4. Non-Recurrence of Certain Costs
Another critical term to address is the treatment of non-recurring costs. These are expenses that are one-time in nature, such as legal fees or restructuring costs, that do not reflect the ongoing operations of the business. It is often negotiated that these non-recurring expenses be added back to EBITDA to provide a clearer picture of the business’s true earning power.
Example Clause: "Any non-recurring costs, including legal fees, restructuring expenses, or other one-time costs incurred during the earnout period, shall be added back to the EBITDA calculation for purposes of the earnout."
5. Adjusted EBITDA for Working Capital or Debt Adjustments
Working capital and debt adjustments may be required to align the business’s financials with the conditions at the time of closing. Some deals specify that changes in working capital or debt during the earnout period will be adjusted in the EBITDA calculation to avoid penalties for the seller if the business’s working capital or debt levels fluctuate post-sale.
Example Clause: "Adjustments to EBITDA for changes in working capital or debt incurred after closing shall be made in accordance with the mutually agreed-upon formula and reflected in the earnout calculation."
Conclusion
Negotiating the terms of an earnout EBITDA calculation is a critical component of many M&A transactions. By carefully considering and explicitly excluding certain costs, such as monitoring fees, strategy fees, and transaction insurance expenses, sellers can help protect their potential earnout payments. Buyers, on the other hand, may want to ensure these exclusions are clearly defined to prevent inflated earnings claims that could result in excessive payouts.
In any case, both parties should work closely with legal and financial advisors to ensure that the earnout provisions are clearly outlined, equitable, and reflective of the true financial performance of the business. Clear communication and well-defined terms can help avoid conflicts and ensure that the earnout process runs smoothly, benefiting both the buyer and the seller in the long run.
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