Understanding Earnouts in Mergers & Acquisitions

Mergers and acquisitions (M&A) are complex transactions that often involve lengthy negotiations between the buyer and the seller. There are many aspects to consider when evaluating the transaction process, one of the most important ones is the payment terms. After all, whether it is raising capital for your company or selling it outright, M&A deals are financial transactions and as is the case with anything finance, it can be broken down into two things: valuation and risk.

When selling a company, one of the most common areas of contention is the price. Sellers have an intimate knowledge of their company and its future, hence they demand a higher valuation. Buyers are usually more conservative and want to limit their risk by paying a lower price, hence they will most likely demand a lower price tag. When this situation arises, how can both parties come up with a win-win solution that fulfills the demands of both sides?

This is where earnouts can serve to break the deadlock. In this article, we will explore the basic concept of earnouts, why they are used, their advantages and disadvantages, and offer some advice on how to leverage it in an M&A deal.

What is an Earnout in M&A?

An earnout is a provision in an M&A transaction that ties a portion of the purchase price to the future performance of the acquired business. Essentially, it means that the seller will receive additional compensation if the business meets specific financial targets, such as revenue or profit milestones, within a defined period post-acquisition.

Why are Earnouts Used?

The process of valuing a company is a very subjective matter. Two parties working on the same financial data on the exact same company can come up with a distinctly different figure for the price tag of the company. This is an inherent attribute of the valuation process: the risk appetite and the assumptions of the valuer is built into the valuation process and the final figure ultimately represents the personal judgements and unique perspectives of the valuer.

There are many ways to value a business, one of the most popular methods is called discounted cash flow (DCF). The DCF model requires three inputs: an estimate of the future cash flow of the business, the forecasted growth rate of the cash flow and the expected return demanded from the investment. Higher cash flow and growth rate will result in higher valuation, while higher expected return will produce a lower valuation. Cash flow estimate and its expected growth rate are heavily influenced by the valuer’s personal view on the economy, the business’ prospects and its operations. 

It is commonly seen that an information asymmetry exists between the buyer and the seller. If you are a seller, you would have more information about your business than the buyer and therefore can have more confidence in the continued success of your business, which is implied in a higher valuation.

The buyer does not have the same level of knowledge. Usually, to bridge this information gap, the buyer would conduct rigorous due diligence into its target to uncover as much information as possible that would aid the buyer in valuing the business.In many cases the buyer simply does not share the seller’s confidence in the prospects of the business. To account for this problem, the buyer will demand a lower valuation.

How does Earnouts Work?

Consider the scenario where you are selling your business. You think that your business is worth at least $90 million. The buyer, on the other hand, is not convinced. They anticipate that the economy may go through a slowdown next year, therefore adversely affecting your business’ revenue-generating abilities. The buyer is only comfortable to pay up to $60 million for your business.

An expert M&A advisor may incorporate an earnout provision in the transaction structure. The buyer will pay the $60 million upfront and the $30 million valuation difference will be paid out contingent upon the achievement of certain predetermined business milestones or financial metrics within an agreed post-sale period.

An example earnout arrangement would be to pay out $10 million each year if the revenue grows by at least 35% each year for the next three years. If the growth target is achieved and the business indeed grows 35% annually each year, you are entitled to be paid $10 million each year. Achieving this target for three consecutive years will see you receiving the full amount of $90 million, which is the initial value you demanded.

The Advantages of Earnouts

As the example above has demonstrated, earnouts are extremely helpful to bridge the gap between the seller's forecast and the buyer's healthy skepticism. Earnouts are especially useful for companies with little operating history but significant growth potential which are notoriously hard to value. Incorporating earnouts allow assets to prove their worth.

If the business is indeed as good as the seller claims it to be, the seller will receive the full amount that they demanded, paid periodically as milestones are fulfilled. If the business fails to reach the predetermined targets, the buyer is not required to make any earnout payments. The implication of this arrangement is twofold: it serves to align the interests of both parties and to protect the buyer from overpaying.

Earnouts compel sellers to leave some “skin in the game”. To be eligible for the remaining contingent payments, sellers must see to it that the business does well even after it has changed hands. Earnouts give sellers incentives to remain involved in the business to help transfer their knowledge and operational know-how to the new management. This is crucial to ensure a smooth transition post-acquisition.

Earnouts can also function to limit the downside risk of buyers. Without earnouts, to break even after paying high valuations on its acquisitions, the forecasted high growth rates must materialize. In the event that this is not the case, the buyer would have grossly overpaid and would have to write-off significant losses on their investment. Earnouts act as a safeguard against this risk: if the predetermined milestones are not achieved, the buyer is not required to make any payments in excess of the upfront payment. In other words, the total amount paid to purchase the business remains in-line with their conservative estimates that fairly justify their offer.

Another benefit accruing to the buyer is the ability to finance a fraction of their purchase with the cash flow from the acquired business. If the business continues to do well and can produce positive cash flow, the buyer can use this cash flow to make the earnout payments to the seller. This allows the buyer to not have to take on additional external capital that may come with unfavorable terms or restrictive covenants.

The Disadvantages of Earnouts

Despite its numerous advantages, it would be wise to exercise caution and be aware of the potential pitfalls when structuring earnouts during the sale of your company. It is a common cause of dispute, with reasons ranging from conflicting interpretations of the target metrics to the inability on the part of the seller to exert enough influence on the direction of the business to achieve the earnout conditions.

For a successful earnout agreement, it is essential for both parties to clearly agree on specific milestones and timelines, such as revenue or EBITDA targets over a period of time ranging from one to five years. It is also important to have a clear definition and understanding of the methodology used to calculate these financial metrics. The most commonly used metric is revenue targets. EBITDA is also regularly used, although it can be sensitive to accounting treatments.

It is also crucial to ensure that you as a seller have enough degree of influence over the operations of the company post-acquisition. This is to make sure that the company remains in the direction you had expected in order to achieve the earnout targets and unlock your contingent payments. If the buyer is to have full control and you are expected to completely exit the business, it can be difficult for earnout payments to materialize.

Earnout period is typically structured to be less than 3 years. While it is in everyone’s favor for the outgoing seller to boost profits, buyers have to be mindful that this behavior does not come to the detriment of long-term business viability. Reasonable governance must be put in place to ascertain that investments that may take longer to pay back are still being undertaken. Marketing efforts must be maintained to keep the business top of mind and R&D projects must still be pursued to keep up with the competition. Cutting back on these expenses will boost short-term profits and maximize the earnout payments if based on EBITDA or EBIT, but adversely harm the future of the business.

Economic downturns, industry shifts or changes in competitive position may impact the performance of the business, thereby also affecting the ability to achieve earnout targets. The rest of the earnout payments could also be in jeopardy should a dispute arise in the first years of the earnout period. And while the concept of earnout payments may seem appealing in theory, the practical implementation of earnouts necessarily increases the complexity of the deal and will be an additional point of negotiation in the deal process.

Conclusion

Transparency and trust are key in earnout arrangements. The seller needs to trust that the buyer will manage the company in a way that maximizes the value for both sides and enables the achievement of predetermined earnout targets. The buyer also needs to have conviction in the seller’s projections and guidance for the business.

Before committing to an earnout, be sure that it is the payment structure that really suits your needs. If there is a notable difference between your price and the buyer’s offer, it is important to consult with your M&A advisor to make sure that your business is ready to be sold and that your demands are commensurate with the state of your business. An expert M&A advisor can craft a win-win solution for both sides and more importantly, help you implement an earnout provision to get as much out of the deal as possible.

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At Alehar, we're deeply passionate about M&A and fundraising, equipping us with the expertise and extensive network needed to carry out transactions efficiently and represent the interests of our clients effectively. Our expertise is particularly valuable for transactions ranging from USD 3m to 200m, as we guide companies through every step of their M&A and fundraising journey (including both equity and debt transactions)