When a business owner wants to sell a business, an often contentious negotiation point arises over the company’s valuation. As you might expect, it is fairly common that a buyer wants to acquire a business (or its assets) for less than what the seller is willing to accept. To bridge the difference, which has come to be known as the valuation gap, many M&A practitioners will incorporate an earnout. Earnouts are additional or contingent compensation paid by the buyer if the seller achieves certain financial or operational milestones.
Buyers especially love to incorporate earnout provisions. For starters, earnouts bind the seller’s additional compensation to the business’s future performance. In essence, an earnout implies that the seller is delivering an investment to the buyer that it believes will maintain or be more valuable to the buyer in the future than the parties can agree to at the time the transaction closes. It allows the business to prove its worth to the buyer. If the business fails to reach certain performance targets, the buyer would pay some lesser amount (or potentially have no obligation at all). For the seller, however, this deferred payment can be frustrating and create uncertainty.
Additionally, buyers often seek earnouts as a source of financing for the acquisition by delaying some portion of the purchase price to a later date (i.e. less upfront cash to close the deal). By doing so, it may able to pay for the acquisition with future cash flow from the recently acquired business and rely less on third party financing.
Figure 1: Benefits and Risks of Earnouts
Key Elements of an Earnout
At a high level, there are three structural elements to an earnout that all parties to a transaction should consider (and need to get right).
Identify the Target Business (or Assets):
In any M&A transaction, it is critical to ensure all parties have a clear understanding of the business or assets being acquired. When an earnout is involved, that clarity needs to persist throughout the term of the earnout. It is fairly simple to track progress of an earnout provision within an acquired business that continues to operate as a subsidiary of the new owners; however, difficulty can arise if the acquired assets are integrated into the buyer’s existing business with no clear delineation between the two. Further consideration should be given not only to how the financials will be segregated, but also to how the earnout calculation is effected by sales to common customers, growth created by synergies or treatment of new and unusual expenses (i.e. does the seller’s earnout include these items).
Identify the Correct Performance Metric:
Most earnout provisions are based on some element of the business’s overall financial performance; however, it is certainly not uncommon to see operational or non-financial metrics used in the sale of a business with very specific assets or businesses with little financial history.
The most common financial metrics for calculating earnouts are (i) gross revenue or revenue collected, (ii) earnings before interest, taxes, depreciation and amortization (EBITDA) and (ii) net income. Revenue based earnouts tend to be the preferred metric for sellers due to the simplicity and reduced malleability; however, does not capture the entire financial performance of the business’s operations. Net income, on the other hand, includes non-operating and/or non-cash expenses that may be more easily manipulated (i.e. a change to the buyer’s accounting policies). As such, EBITDA commonly serves as the baseline metric for most financial earnouts due to its ability to capture the entire financial performance (both revenue and cost) without considering non-operating expenses.
Depending on the characteristics of the target business, non-financial metrics may be more appropriate and, if used, are often tied to specific key operational components of the business. For instance, customer retainage, product development milestones or regulatory approvals (i.e. pharmaceutical approvals).
Finally, when determining the appropriate metric to use for an earnout, careful thought should be given to the components of the calculation itself and the accounting principles involved (i.e. what exactly is involved in calculating EBITDA). Many generic earnout provisions default to only allow financial statements prepared under Generally Accepted Accounting Principles (GAAP). Unfortunately, sellers who didn’t previously use GAAP may be surprised to learn of a substantially lower EBITDA or net income at the first earnout payment. This can be mitigated by restating the seller’s EBITDA under GAAP prior to closing or, alternatively, utilizing a modified GAAP calculation at closing and any subsequent calculations of earnout.
Identify the Earnout Period and Structure:
The earnout period refers to the time between the transaction closing date and the payment of the earnout. Generally, sellers prefer a shorter earnout period in order to receive payment sooner. Conversely, buyers prefer a longer period in order to ensure they are capturing the “correct” value and to delay financing as much as possible. Another area to consider when negotiating the earnout period is the post-transaction involvement of the seller and how much influence they will have on the success on the business under the new management.
Bonus: Other Considerations
The three elements we’ve discussed thus far only scratch the surface of earnouts and the complexities that can exist within this type of pay out structure. Consider the following scenarios:
Scenario 1: The owners of a newly acquired business have increased their sales and marketing budget to drive growth. Unfortunately, these sales efforts take time to develop into customers. The seller’s earnout is to be paid in a few months and the additional sales and marketing expense has burdened the value of the earnout.
Scenario 2: When the seller sold its business, the economy was thriving and there were no signs of a recession. Six months into a one year earnout, the economy crashes and the business has suffered, resulting in a significantly reduced earnout.
Scenario 3: A strategic buyer has acquired a seller’s business (who is a direct competitor) with 60% of the purchase price paid in a one year earnout. Three months after closing, it becomes apparent that the buyer only wanted to remove its competition from the market and was less concerned with the success of its new acquisition.
Scenario 4: A private equity has acquired the interest from the seller as an add-on to its existing portfolio. One year into a two year earnout, the private equity sells its portfolio company (and the add-on with it), creating uncertainty on how the earnout will be effected.
Scenario 5: The financial metric used in determining the earnout turned negative for the earnout period and there is nothing in the earnout clause that addresses the situation. The buyer now believes it is owed compensation from the seller.
Unfortunately, earnout agreements are one of the most disputed areas of a transaction, one that commonly ends up in costly litigation. One way to mitigate a costly post-transaction dispute is to ensure that the governing documents contain clear definitions and language that formalize exactly how the earnout is to be calculated and paid out (and the process to resolve any disputes that may arise). Addressing the key elements above can help put your earnout on the right track.
Have a question about earnouts or need assistance with an earnout dispute? Contact us.