What is an Earnout?
An earnout is a risk allocation mechanism for the acquirer wherein the purchase price is contingent on the “future performance” of the target company. The acquirer pays a majority of the purchase price upfront, at the time of closing the deal, and the remainder is contingent on the performance of the target.
For example, if the seller thinks the business is worth $100 million and the acquirer believes it is worth $70 million, they can agree on an initial price of $70 million and the remaining $30 million can form part of the earnout. The $30 million may be contingent on factors such as revenue, EBITDA margins, earnings per share, or retention of key employees.
Source: Private Equity Acquisition Model from CFI’s Financial Modeling Templates Course
Earnouts in an M&A transaction
Disagreements about a company’s valuation in any deal are not something new. The seller wants to get the highest possible price, and he/she may believe that the business is worth more than the acquirer thinks. The acquirer, on the other hand, is wary about the target company’s growth or retention of key employees or major customers. One possible solution to this dilemma is earnouts, which help bridge the gap between an optimistic seller and a skeptical buyer.
Structuring the earnout is an important part of the M&A process.
When Earnouts Gain Popularity
- Valuation Gap – When the acquirer believes the projection used by the target company includes hockey-stick valuation and is unrealistic, it will try to go for a lump sum payment as per their projection ($70 million) and the remaining ($30 million – valued extra as per the seller) as earnouts over 2-3 years.
- Financing – Higher interest rates in the market can also be one of the reasons why the acquirer will want to make a delayed payment or choose to pay with capital that will be generated in due course of time from the acquired company.
- Smooth Transition – The buyer also likes to push some payment to ensure a smooth transition and obtain the complete support of the target to conduct the business in the best possible way until the deal is completed.
- Incentive-based Compensation – If the acquirer is of the opinion that it will take them 2-3 years to run the business without the existing management of the target company, it will try to keep the management’s interest in the business by way of earnouts.
- No Delay, No Regrets – Sellers mistakenly wait to sell because they can show excellent growth in a year, but an earnout structure allows them to avoid this mistake in a more effective way.
- Startups – Earnouts are often used for companies with little operating history but with significant growth potential.
Structuring an Earnout
Structuring an earnout is very important, as it involves how the business will run, who will have what kind of control over the business, and other key elements. A combination of all these decides what the company achieves in terms of revenue, EBITDA, contribution from top customers, etc., which in turn decides the payout for the seller. Below are a few considerations for structuring earnouts:
- Key Executives – A company doesn’t grow because of just one person; it requires the effort of a complete team. Hence, it becomes very important for the seller to include key executives in his/ her plan, as they can be a key resource to drive revenue and achieve projected EBITDA margins.
- Length of the Contract – The seller may not like to work for very long according to the rules laid down by the new buyer and may want to avoid future differences. Keeping that in mind, it would be wise to keep the contract period short and plan out the earnouts in that period only. If everything goes fine, then the seller and the buyer can always renew the contracts and renegotiate the terms of employment.
- Control – It’s unfair to cut the earnouts of the seller if a target is not met while he does not control the business. To avoid such a situation, it is very important for the buyer and the seller to decide on the business plan and the kind of control the seller will exercise post-acquisition. The seller may wish to oversee the operations, marketing, and other areas that can drive revenue and margins. If the acquirer keeps a respectful distance and seems to be giving the control, it should be seen as a good sign.
- Financial Metrics – Common financial metrics include revenue, EBITDA, net income, and earnings per share (EPS). Sellers prefer to base the earnouts on revenue, which is difficult for the buyer to manipulate but easy to achieve. There may also be a situation where the sellers of the business take up projects with low margins just for the sake of revenue. Keeping this in mind, buyers always prefer to achieve a combination of revenue and margins for earnouts.
Technology and service companies with high growth potential are some of the companies that are mostly tied to earnouts in an M&A deal.
Disputes and Resolution on Earnouts
Generally speaking, the buyers prepare and present the financial statements and other factors on which earnouts depend. However, the sellers are afforded complete opportunity to review the same and question the calculation of the earnouts. The definitive agreements will also include arbitration clauses to resolve any dispute in an effective and timely manner, such as the appointment of an independent accountant or auditor.
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