Explaining Earnouts

by Jan H. Raymond

A logistics company sale is rarely an “all cash” transaction. The sale price is generally split between a cash payment at the Closing and the remainder paid out over some negotiated period of time. This back-end payment is called an “earn out”.

The reason it is called an earnout is because it has to be “earned”. In other words, it is not guaranteed.

For asset-light logistics companies, a buyer values the business based on the revenue stream. Even for asset-heavy logistics companies, the revenue stream is a major part of the valuation. The buyer will perform an ROI (return on investment) analysis to justify the sale price. The ROI analysis includes presumptions about the continuity of the revenue stream post-Closing. Therefore, in a typical logistics company purchase and sale agreement, the earn out will be tied to warranties about the continuation of the revenue stream.

The Earnout And Its Related Warranties Have Multiple Moving Parts:

1. Length — how many years the earnout is paid
2. Distribution — how much of the earnout is paid each earnout year
3. Adjustment — how much is the earnout increased or decreased based on the revenue stream actualized versus warranted
4. Warranty basis — what measurement of revenue is used to measure earnout achievement
5. Attribution — what revenue actualized will be credited against the warranted amount

1. LENGTH

Earnouts can be as short as one year or as long as five years but are typically two or three years in length. This is important because the longer the earnout period, the less certainty there is about the company’s continued performance and therefore the ability to receive the full earnout amount and also because “a dollar today is worth more than a dollar tomorrow”. As such, the true value of the deal is lower the longer the earnout period.

2. DISTRIBUTION

The distribution of the total sale price assigned to the earnout period is typically evenly distributed (e.g. a three-year earnout would be 1/3, 1/3, 1/3 each year). However, that is not always the case. The distribution formula is important because of the discounted value of future dollars.

3. ADJUSTMENT

Because the buyer’s ROI analysis is based on the continuity of the revenue stream, if the business underperforms those assumptions post-Closing, a lower value will be imputed to the business and this is reflected in a reduction in the earnout payments. How much each earnout payment is adjusted is an important negotiation point. Some agreements provide for a “prorata” adjustment (i.e. if the revenue received is 10% less than the warranted amount, then the earnout payment is reduced by 10%). Others have a non-prorata formula typically reverse engineered from the purchase price multiple (e.g. if the multiple is 5x then the earnout will be reduced $0.20 for each $1 of revenue shortfall). As you can see, this negotiation is material to the likelihood of a full achievement of the sale price.

At Logisyn, we negotiate strongly for a fair adjustment formula that includes an UPWARD adjustment if the business outperforms the ROI assumptions/warranted amounts. Negotiating for the upside adjustment also puts pressure on the buyer not to be excessive in their downward adjustment formula because they will suffer the same excess on the upside to their detriment. This negotiation also may result in negotiation of a “collar” on the adjustment. A collar is a limit on how much the earnout payment can be adjusted (either up or down).

4. WARRANTY BASIS

The revenue stream that is warranted for earnout purposes is tied to the revenue stream used to calculate the value/sale price. What the seller is warranting is that the business will continue to perform at at least the level it performed during the valuation period (Trailing Twelve Months or an average of some number of prior years). Most warranties are based on 100% of the measured revenue stream. Some presume some degree of growth so are higher than 100%. The real issue is that once the company is sold, the sellers are no longer in control of the business and therefore the ability to affect the post-Closing performance in order to achieve the revenue warranty is beyond their control. In particular, they cannot control the adding of expenses to the business (either in the form of new debt to finance the purchase or operation of the business or other expenses planned to increase business in the future but not necessarily during the earnout period). As such, at Logisyn, we negotiated strongly for the revenue warranty to be based on Gross Profit and not on Net Income. Therefore, the earnout will be achieved as long as the business coming in the door remains as warranted regardless of what expenses are laid upon the business by the new owners.

5. ATTRIBUTION

The single biggest source of dispute on earnout calculations is what revenue is credited to the sellers in the post-Closing operation of the business. At its simplest level, the sellers are credited with all of the revenue from the clients as of the Closing for the service lines provided to them pre-Closing.

However, there may be clients who have not done business with the company for a month or more. It is important to have a measurement period that includes all customers of the company at any time during that measurement period (typically one or two years pre-Closing). Also, how do you deal with the revenue generated post-Closing to the buyers but at the buyer’s business locations other than the seller’s locations? How do you deal with revenue generated post-Closing to the buyers for service lines offered by the buyer that was not offered by the seller?

As you can see, negotiation of earnout provisions have multiple opportunities to increase or decrease the net proceeds to the sellers. At Logisyn, we focus not on the stated sale price, a “number” on a purchase and sale agreement but, rather, the net proceeds to the sellers; how much money our clients actually get to put in their pockets after all is said and done. Our decades of experience and knowledge in negotiating logistics sale transactions assures our clients that we understand all of these moving parts and will work diligently and professionally to protect our clients’ interests.

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