Part I of III in a discussion about earnouts
Many sellers experience the anxiety of knowing too little about an earnout that isn’t meeting expectations. Reports of a selling company’s performance often contain little information other than whether or not the earnout targets have been achieved. If the seller isn’t granted information rights under the merger agreement, an earnout that isn’t performing could descend into a dispute, even if the relationship between the seller and acquirer was civil when the deal closed.
Having comprehensive information rights in a merger agreement can save both parties resources when earnout expectations aren’t being met, because they provide insight into performance and options for solving problems before they escalate.
Ideally, information rights would include the following features:
- Periodic written reports with a reasonable level of detail. Report frequency depends on the nature of the business and the earnout milestones, but our data shows that 35% of transactions only require reporting upon achievement or at the end of an earnout period. Inadequate frequency of reporting can leave sellers grasping for more information about the performance of their business. Sellers should consider how often they must receive reports to adequately track earnout status and make sure this is reflected in the acquisition agreement. Usefulness of reports also depends on the level of detail within them. Sellers should insist that financial reports include sufficient detail regarding the components of the bottom line number. Event-based reports should provide an update on material events as of the most recent report and the ongoing activities aimed at achievement of milestones.
- Right to request reasonable supporting information. The seller representative should have the right to request and review information that was not directly included in the report but that supports the calculations. Particularly common in financial earnouts, this would include sales reports, financial statements, workpapers, and in many cases, formal audit rights.
- Right to request a meeting with acquirer representatives. The right to request a meeting with relevant personnel from the acquirer can be crucial in keeping earnouts on track, particularly in event-based milestones. At a minimum, meetings allow deal parties to share information and establish a productive relationship. In many cases, they can iron out miscommunications that result from written reports and resolve a brewing dispute before it escalates.
- Consistent reporting standards. Reporting standards should be consistent whether the business is close to meeting the target or not. In some cases, the acquirer is required to provide less information to the seller if performance isn’t meeting expectations than if earnout targets are being achieved. Allowing sellers less information when things are going poorly only perpetuates a difficult situation.
Since 2012, the median amount of earnout potential has increased from 46% to 103% of the closing payment. Now more than ever, it is important that sellers ensure that their interests in an earnout are protected. Fulsome information rights in the merger agreement are a primary means to avoid a dispute if things don’t go as planned. We strongly recommend that sellers and their counsel focus on these provisions, and find a professional seller representative that can navigate the terms of a merger to best protect them in their next deal.
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