If you’re a middle market deal maker you have undoubtedly run across an earnout. In fact, earnouts have become a common mechanism to bridge the so-called “value gap” in many middle market M&A deals. Despite its common place, however, many sellers still have a hard time getting comfortable with its use, and in an uncertain economic environment like the one we currently find ourselves in, it’s no wonder why that discomfort is so persistent. In fact, if a seller had incorporated an earnout in a pre-COVID deal, they are most likely looking at a significantly reduced payout in 2020 (and possibly 2021). As a result, sellers are more fearful of stolen value now more than ever before and buyer’s are loving that they don’t have to pay full value (although cringing at the prospects of their recently acquired asset).
The following examines a slightly different preceptive on earnouts by looking deeper into the motivations behind its use and will offer up a unique tool to equalize some of the risk back to the buyers in a manner that remains acceptable to both buyers and sellers while still providing incentive to the new owners of the business.
Motivations
One of the primary functions behind the use of an earnout is to address the buyer’s concern over paying the right value for an acquisition (which, at its core, implicitly includes buying future cash flows and the uncertainty in achieving those cash flows). As such, an earnout alleviates the buyer’s value concerns by paying for a portion of the purchase price based on future earnings or cash flows, which presumably aligns more with the true value of the acquired business. A secondary function is that the buyer is able to finance a portion of the transaction with future cash flows of the business, which can be a lucrative alternative to bringing more cash to closing (either through additional equity or higher levels of debt).
Unfortunately, there is a fundamental shift in the allocation or risks between the buyer and seller when an earnout is introduced. Take the following thought provoking questions for instance:
- Who should bear the risks if the company suffers a non-systemic or business specific downturn in profitability? What if the seller is no longer involved in the day to day management of the business and the new ownership has made changes to how the business is operated?
- Who should bear the risks if the entire global economy suffers a significant downturn at no fault of the seller or buyer (i.e. systemic risk)?
- What if the buyer has a robust plan to grow revenues and expand profitability, but has refrained from executing it in its entirety for fear of sharing in the growth at the earnout date OR simply wants to pay a lower earnout amount?
- What if the buyer promised to share in an increase in post-closing synergistic value, but those synergies never panned out?
Depending on the answers to the above questions, it is possible to concluded that a classic earnout structure may not be an appropriate mechanism to bridge the valuation gap, especially if the allocation of risks are perceived to be out of balance. However, with a slight modification to the classic earnout structure, buyer’s and seller’s may be able to salvage the deal and deepen the aligning of the buyer and seller’s interest.
The Earnout Collar
If a deal has reached an impasse over the structure over the earnout, its quite possible that one of the parties is not satisfied with how the aforementioned risks are allocated. In fact, it’s often the seller who is concerned with the complete loss of the future earnout payment. The existence of such an impasse may be overcome by introducing the concept of the Earnout Collar. The Earnout Collar modifies the classic earnout structure (read Earnouts: Bridging the Value Gap to learn more about traditional earnout structures) by incorporating a minimum payout amount (or “floor”) and a maximum payout amount (or “ceiling”), essentially locking in a payout range.
Figure 1: Payout of Classic Earnout versus Earnout Collar
The following presents a few of the potential benefits of an Earnout Collar.
Known Payout Range: An Earnout Collar identifies the range of acceptable earnout values, which may reduce the threat of a post-closing dispute. It allows the parties to develop some level of agreement on the payout amount while maintaining the spirit and intent of the classic earnout structure.
Focuses on Probability: The introduction of the Earnout Collar facilitates a more reasonable and targeted discussion on the probability of achieving future earnings. In many instances, buyers and sellers conclude that the extreme ends of the earnout are not likely under normal economic conditions and therefore, can be reasonably removed from the earnout equation. In many instances, the results from the Upside and Downside Cases of the financial model provide insight into the upper and lower bounds of the Earnout Collar.
Buyers Alignment and Value Incentive: Earnout Collars keep new ownership engaged in the success of its newly acquired assets by motivating them to achieve the ceiling value (knowing they won’t have to pay more once the threshold is breached). It encourages new owners to immediately begin its planned growth initiatives instead of waiting until the earnout is complete.
Sellers Alignment and Comfort: Earnout Collars provide comfort to the seller that no external threats to the business will completely diminish the earnout’s value, while keeping the seller’s interest aligned with achieving the range of profitability indicated by the earnout collar.
Final Note
Obviously, every transaction is different and requires a different approach. The Earnout Collar is certainly not a one size fits all solution; however, it is a tool that, in certain instances, can be introduced to create a deeper alignment and overcome the perceived imbalances of risks created by traditional earnout structures. Contact us for more information on how to properly incorporate an earnout or earnout collar and protect value.
