Recent changes in U.S. trade policy have created a lot of uncertainty for business owners, especially those who buy or sell products internationally. New and proposed tariffs (taxes on imported goods), along with retaliatory tariffs, can be announced or rolled back with little warning. This makes it hard to predict how a business may do in the future, as past performance may not be a strong indicator when considering future financial forecasts impacted by these trade limitations—which, in turn, makes it difficult to agree on a fair price when considering the purchase price of your company.
If your business relies on global supply chains or sells to customers beyond the U.S., these unpredictable tariffs can have a large impact on your profits. For many companies, this has created an additional challenge in the M&A market; buyers may worry that tariffs and other trade barriers lower margins or limit market access, while sellers do not want to be penalized for global macroeconomics far outside their control.
What Is an Earnout and How Can It Help?
The increased uncertainty is one of many factors that could cause a discrepancy between the price the seller believes the company is worth versus the price the buyer thinks is worth the risk involved. To help bridge this valuation gap, buyers and sellers are now more frequently turning to earnouts and other contingent consideration structures. An earnout is a contractual provision whereby a portion of the purchase price is paid at closing, and another portion (or portions) is contingent on the target company achieving certain financial or operational performance goals within typically a few years after the closing of the transaction. For buyers, this limits the amount of capital needed up front, which is helpful in a cash-conscious market, and lowers risk if the business is impacted in the near future, while also giving their financing sources more confidence to lend in a speculative environment. For sellers, earnouts provide the chance to receive more money than a risk-averse buyer would otherwise be willing to pay up front, if the seller believes the earnout targets are achievable despite, or perhaps due to, the uncertainty.
While earnouts are often used when previous owners or key employees stay on to help operate the company, they are also a way for buyers to delay some payments to see if major circumstances arise that could undermine the predicted valuation and performance of the company. This approach became especially relevant during the COVID-19 pandemic, and, much like then, companies today need to think creatively to address the unique challenges caused by increased tariffs at a level not seen since before World War II.
Key Points to Consider When Using Earnouts
No two M&A deals are the same, and there is no one-size-fits-all answer to an earnout provision. Each one will be unique, based on the companies involved, their industry, the market at the time of closing, both sides’ predictions of future earnings, and other deal-specific considerations. The following are some issues both sides should take into consideration while drafting earnouts to address these uncertainties and bridge the valuation gap:
- Clear Goals: The earnout should spell out exactly what targets need to be met—such as revenue, profit, or other measures. In today’s environment, you might want to use targets that account for the impact of tariffs, like “tariff-adjusted” profits, financials that exclude specific cost line items, or using non-financial, operational performance goals such as key business activities, milestones, or KPIs. Avoid ambiguous language to help avoid disputes down the road.
- Payment Structure: Earnouts can utilize a multitude of payment structures, including a minimum and maximum amount that can be paid, or tiered payments that can help absorb some of the volatility in the future, as opposed to an all-or-nothing approach.
- Change-in-Law and Force Majeure: Sellers may wish to negotiate language in the agreement to explicitly address how regulatory changes, including tariffs, will impact or change the calculations and thresholds for earnout eligibility.
- Dispute Resolution: Earnouts are one of the most common sources of legal fights after a sale. Including clear rules for resolving disagreements—such as mediation or arbitration—can save time and money.
- Seller Protections: Sellers may want extra protections, like holding some money in escrow or requiring performance guarantees, to ensure they get paid.
- Buyer’s Responsibilities: Sellers should consider covenant language defining the buyer’s post-closing conduct expectations—explaining how the buyer must act and steps they should take to best position the business to reach the earnout payment thresholds—so sellers have a fair shot after the business is out of their control (or even if the sellers are staying on in some capacity).
- Timing Considerations: In a time of tariff uncertainty, buyers may look to prolong closing in an effort to get a clearer picture of the financial landscape. This extension of time, however, could prove to be risky for sellers, who may miss out on other opportunities in the interim.
- Additional Concerns: While earnouts can help mitigate tariff turmoil, it is also important to consider additional protections in the agreement, including:
- Additional due diligence to understand how tariffs may affect your particular business;
- A more robust “material adverse effect” clause, potentially articulating the ability to walk away in the case of certain events (i.e. larger tariffs); and
- Broader representations and warranties and potentially additional insurance.
Conclusion: Earnouts as a Solution in Uncertain Times
Earnouts are no longer just price bridges; they are also risk management tools for both sides of a transaction. For companies considering M&A transactions in this environment, understanding how to navigate the risks and opportunities surrounding earnouts is crucial. With buyers more cautious and sellers often unwilling to capitulate on the price of their company when it comes down to potential future risks, earnouts and other contingent payments create an opportunity for both sides to reach a deal. In these times, it is essential for both parties to engage in comprehensive, creative negotiations and seek expert legal and financial counsel to mitigate risks, maximize profits, and reach a deal that can withstand any tariff storm.
