Earnout Alchemy: The Art Of Unlocking Value In Business Transfers

Earnouts, although are often a valuation troubleshooter in a business transfer, they require in-depth commercial negotiations and careful drafting in the transaction documents, to grease the wheels of a business transfer.

Business valuation is paramount for dealmakers in business transfers, and is often, if not always, a bone of contention between a purchaser and a seller. Such valuation is not only based on past performance, assets, and regulatory compliance of the ‘undertaking’ but is also reliant upon prospective factors such as market demand, growth potential, competitive advantages, and other aspects to the extent of producing lucrative output for the principals. In reference to these factors, often, there are divergent views on the future performance of the assets being transferred, thereby tugging the valuation to various corners, and postulating multiple uncertainties.

As an instrument to bridge the gap between such divergent views of the parties on the valuation and to hedge against the uncertainties arising out of transfer of undertaking, parties frequently use ‘earnout’ as a mechanism to provide additional consideration to the seller, post-closing of the transaction, which may be tailored to be made contingent to the occurrence of various conditionalities such as future performance of the transferred asset or achievement of agreed milestones.

Constructing Earnouts: A Pacifier to Parties

Depending on the structural alignment between the parties and the tax implications thereof, earnouts may or may not form part of the documented ‘purchase consideration’ of the business undertaking being transferred and would alternatively, be paid out as additional remuneration to the seller and other senior management being absorbed by the purchaser.

In this context, typically, earnouts are structured as a function of achievement of milestones, which may be either revenue based or non-revenue based outcomes. Where ‘revenue based’ outcomes are opted for, the milestones pertain to the transferred undertaking attaining targeted EBITDA, revenues, earning per share, business expansion, etc. In such cases, it is vital for the seller to negotiate appropriate post- closing control and oversight over the operations and management of the business undertaking to accordingly steer and navigate it towards the desired outcomes. To this effect, defining clear and precise standstill provisions (for the duration of the earnout period) is crucial to establish the required control over the undertaking and to ensure suitable co-operation from the buyer as well. Here, alignment and documentation of the principles on which such milestones would be accounted and computed upon their achievement is imperative, since any ambiguity thereto could be a guaranteed catalyst for initiating a dispute.

Non-revenue based milestones are opted for in cases where the parties are more focused on achieving qualitative outcomes from the seller and its senior management, such as regulatory approvals, development of some intellectual property, research and development, etc. Such milestones are more commonly used for start-ups or where the business is pillared on human skill, especially where employees possess specialized knowledge about operations, marketing, or networking (such as businesses involved in healthcare delivery and diagnostics). Here, it may be prudent for the parties to frame explicit and unambiguous criteria for determining the performance quality in fulfilling the milestones, where for a faster churn, such milestones could be broken down into smaller stages which are required to be completed in a time-bound manner.

Walking the Legal Tightrope

Any discourse on earnouts requires bearing in mind that receipt of such earnouts has corresponding tax implications on the seller. Depending on the construct of the earnouts, the same may either be taxed as profits in addition to salary (where the earnouts are being paid as part of the seller’s remuneration)¹ or be subject to capital gains tax, where the earnouts are documented as part of the purchaser consideration.

The tax incidence and the implicated quantum thereof are one of the key considerations for sellers and buyers to re-structure their transaction, to avoid additional monetary leakage.

Moreover, commercial considerations may become slightly more complicated in case the prospective buyer is a non-resident person/ entity, since they are not permitted to operate business in India without establishing an Indian place of business. To clarify, although a non-resident entity may open a branch office, a liaison office, or a project office (with the prior approval of the Reserve Bank of India), for a limited and short-term purpose which would be subject to certain conditionalities, conducting full- fledged business operations would require setting up of a permanent Indian entity.² Owing to this, interested non-resident buyers would require to either collaborate with or set up an Indian entity to consummate a business transfer, as per the norms and sectoral caps of the extant Foreign Direct Investment (FDI) Policy. Consequently, the conventional routes for providing earnouts (as stated above) to the seller management may not always be commercially the most desirable course of action, and therefore, calls for seeking alternate and unconventional mechanism to achieve the same outcomes.

The Road Less Taken

Transactions where the conventional earnout payments are not commercially feasible or as attractive as an approach, the parties may mutually discuss to consider issuance of equity-linked instruments to the seller in the buyer’s entity. In such a scenario, although the parties may decide to issue equity shares, in our experience, instruments like compulsorily convertible preference shares (CCPS) give greater flexibility to the parties in terms hedging against risks and ensuring achievement of milestones.

The key aspect which may provide CCPS an edge against equity share is that the terms of issuance of a CCPS could be tailored to be made as specific to the transaction as may be required. Basis discussions amongst the stakeholders, the parties may derive a formula whereby the conversion ratio of a CCPS to an equity share may be made subject to various contingencies such as timely achievement of the agreed targets, any indemnity claims arising on the purchaser, and provisions such as good leaver and bad leaver.

For instance, if the performance of the seller is such that the earnout milestones are either not attained or attained well below the targets, then the conversion ratio of the CCPS to equity can be customised to be reduced from the usual 1:1 ratio. Alternatively, where the seller has outperformed in relation to his targets, the conversion formula can be used to reward the seller by providing a higher conversion ratio. Such conversion would have a direct impact on the amount of consideration the seller may receive against the sale of the said CCPS, thus, incentivising the seller to work towards completion of the targeted goals for achieving an upside in the share valuation.

Wrapping Up

Earnouts, although are often a valuation troubleshooter in a business transfer, they require in-depth commercial negotiations and careful drafting in the transaction documents, to grease the wheels of a business transfer. Too cumbersome and practically unattainable milestones may not be in the best interest of either of the parties, and therefore, parties should pay heed to the fact that earnouts in business transfers should be built with the intent of retaining the management and building the composite value of the purchaser, which now subsumes the seller’s business.

Disclaimer – The views expressed in this article are the personal views of the authors and are purely informative in nature.