As businesses grow and expand, it is common for owners to seek outside investment to fund further development. One common way for investors to invest in a company is by purchasing a percentage of the company`s shares. When this happens, a share purchase agreement (SPA) is typically used to document the transaction and protect all parties involved.
While many SPAs are straightforward, some may include an “earnout” clause, which can be more complex. An earnout is a contractual provision that ties a portion of the purchase price to the future performance of the company. Specifically, an earnout provision allows the seller to receive additional payments based on achieving specific performance targets after the initial sale has taken place.
Earnouts can be beneficial for both the buyer and seller as they can help bridge any valuation gaps, minimize risk, and align the interests of both parties. However, they can also be challenging to negotiate and draft correctly.
When drafting an earnout provision in an SPA, it is essential to consider the following key issues:
1. Determine Performance Metrics
Before the earnout provision can be included in an SPA, the buyer and seller must agree on the performance metrics that will be used to determine whether the earnout has been met. It is crucial to choose realistic and measurable metrics that both parties can agree upon. Examples of performance metrics include revenue, EBITDA, or gross profit margins.
2. Set a Payment Schedule
The SPA should also clearly define the payment schedule for any additional earnout payments beyond the initial purchase price. It is advisable to structure payments over several years as it is rare for a company`s performance to change significantly in one year.
3. Avoiding Disputes
Finally, it is crucial to include provisions in the SPA to avoid disputes. An arbitration clause can be used to resolve any disagreements between the buyer and seller over the earnout provisions. Additionally, it is essential to ensure that the seller has access to the company`s financial information and can independently verify the performance metrics used to determine the earnout.
In conclusion, an earnout provision can be an effective way to bridge the valuation gap between the buyer and seller, minimize risk, and align interests. However, when drafting an earnout provision in an SPA, it is crucial to consider performance metrics, payment schedules, and dispute avoidance. By working with experienced legal and financial professionals, both parties can create an earnout provision that benefits everyone involved.