During the process of structuring and/or negotiating mergers and acquisitions (M&A), there is often a meaningful gap between the views of the buyer and the seller regarding both the valuation of the target business and the overall risks involved. These views may arise due to many factors related to the profile of the target, such as projected financial performance, high levels of customer concentration, or the target management team’s importance to the future success of the business.
An earnout is a common structural and financial arrangement designed to help bridge these gaps, allowing both parties to feel that they have achieved a fair deal in terms of purchase price and/or risk sharing. Below is a more detailed look at what an earnout entails, along with some of the more commonly seen advantages and disadvantages of the structure.
What is an earnout?
An earnout is a negotiated purchase price structure under which a portion of the consideration in an acquisition is held back from the closing and potentially paid at a later date (or dates), contingent upon the target company achieving certain performance metrics post-closing. In most cases, earnouts constitute no more than roughly 40% of the total purchase price consideration, and the earnout payment(s) are fully paid no later than three years post-closing.
The specific terms and conditions of the negotiated earnout structure are detailed in the definitive asset or share purchase agreement signed by the parties to consummate the transaction. Earnouts can be structured around several metrics, including but not limited to the following:
Financial performance. This is probably the most common basis for an earnout structure. Depending on the profile of the target business, metrics can include revenue, gross profit, net income, or earnings before interest, taxes, depreciation and amortization (EBITDA). An earnout based on profitability is often more challenging to negotiate. In theory, the buyer can make decisions after closing that can have an impact on the target’s profitability, potentially negating the likelihood of the earnout payment(s) ultimately being paid in full.
Revenue levels related to certain key customers. In a target business with higher levels of customer concentration, a buyer may wish to mitigate the risk of certain customers leaving the target business post-closing. In such cases, an earnout may be structured under which the ultimate payment of the earnout consideration is based on whether those key customers continue to purchase from the target company at a negotiated level over a specified period.
Retention of key management. A buyer may predicate an earnout payment on a key manager or managers remaining with the target business for a certain period. This is often the case when such managers have deep knowledge of the business and/or are crucial to the continuation of the target’s customer relationships, such that their retention is critical to the target company’s ongoing success, through a transition period and beyond.
Advantages of earnouts
Mitigates risk for buyers. By tying part of the purchase price consideration to future performance, buyers may ensure they are not overvaluing the target business based on optimistic forecasts that may not materialize.
Aligns interests of both parties. Sellers are motivated to ensure that their company performs well post-acquisition, as a portion of their ultimate sale proceeds depends on the business achieving specific performance targets.
Facilitates deals. Earnouts can help bridge valuation gaps between buyers and sellers. When both parties have different views on the company’s worth, an earnout can provide a compromise by allowing the seller to potentially receive a higher price based on future performance.
Preserves liquidity for buyers. By deferring part of the purchase price, earnouts may allow buyers to manage cash flow more effectively. This can be particularly advantageous for buyers who need to preserve liquidity for working capital for other operational needs.
Disadvantages of earnouts
Complexity and disputes. Earnouts can complicate the acquisition process, as the calculation of and agreement on performance metrics can lead to disputes between the two parties. Clear terms and robust metrics are essential to minimize misunderstandings.
Potential for manipulation. Sellers could engage in short-term tactics to meet earnout targets, potentially compromising the long-term health of the business. This can be a risk if the earnout metrics are too closely tied to short-term performance.
Management challenges. If the seller remains involved in the company post-acquisition, the buyer may face challenges in integrating the seller’s management style with their own. This could impact the company’s performance and, consequently, the earnout.
Uncertain outcomes. Because the final purchase price is not known until the earnout period concludes, this can create financial unpredictability for both parties.
Earnouts can be a valuable tool in the M&A landscape, providing a mechanism to bridge valuation gaps, share risk and align incentives between buyers and sellers. While they offer several advantages, they also come with potential drawbacks. Both parties should carefully consider these factors and structure an earnout agreement that addresses potential issues and ensures a mutually beneficial transaction.