Understanding and Accounting for Earnouts in M&A
Earnouts are a vital bargaining tool used to align the interests of the buyer and seller in Mergers & Acquisitions (M&A). Their purpose is to bridge valuation gaps between both parties and ensure additional compensation is paid if a business achieves predetermined financial targets after it’s sold.
The implementation of earnouts can be complex as part of any M&A deal, requiring buy-in from stakeholders both sides of the deal. However, they can also be an important negotiating tool for getting deals over the line. So, what is an earnout in M&A, and what are its benefits in the modern business world? This article will explore the key aspects of earnouts and highlight their pros and cons.
What is an earnout in M&A?
An earnout refers to a contractual arrangement that provides the seller of a business with additional compensation if the business goes on to meet pre-agreed financial goals in the future. Typically, an earnout will be a percentage of the gross sale or earnings of that business.
When uncertainty exists about the future performance and revenue potential of an acquired business, the buyer and seller may include an earnout in the transaction. Earnouts are commonly based on the business meeting revenue targets, profit margins, or other key performance indicators after the sale is complete.
Here’s what an earnout could look like:
Picture the scenario: an owner selling a business demands a higher price than the buyer is willing or able to pay. An agreed earnout provision may then stipulate a £1 million purchase price plus 3% of gross sales over a certain period, say the next two years.
A more detailed example could relate to a company with £50 million in sales and £5 million in earnings. A potential buyer is found, but they’re only offering £250 million, which is well below the owner’s £500 million estimation based on future growth and revenue prospects. In this case, an earnout may be used to bridge the financial gap between the offer on the table and what the seller wants from the deal. In real terms, this could amount to a £250 million upfront cash payment by the buyer followed by a £250 million earnout for the seller if sales and earnings reach £100 million within a three-year period, or a £125 million earnout if sales only reach £50 million.
How is an earnout structured?
Other than cash compensation for the sale of a business, there are many different factors to consider when structuring an earnout. These include:
- Identifying the key employees within a business and deciding whether an earnout extends to them.
- The executive’s role within the business post-acquisition.
- The length of the earnout contract.
If the seller of a business has agreed to an earnout, they are likely to have a number of concerns that should be addressed. These concerns include the following:
- Are earnout financial milestones and targets achievable in a reasonable timeframe?
- Are there ways to guarantee the buyer doesn’t drop operational standards in a way that negatively affects revenue and therefore earnout payments?
- Are potential earnout payments significant enough to delay the seller from receiving a full fee upfront?
An earnout is structured in this way because company performance is linked to management and other senior figures in the organization. Therefore, should these employees leave the company, it may struggle to achieve its financial goals that were pre-agreed during the earnout structuring process.
Additionally, accounting expectations should be specified as management decisions could directly affect financial results. Similarly, an earnout should also incorporate any current or future changes in strategy including investment opportunities that may negatively affect current results. The onus will then shift to the seller to find a practical and equitable solution.
Finally, it’s important to include which financial metrics will be used to determine the earnout. This is because some metrics are more beneficial to the seller, and others to the buyer. This is likely to give rise to disagreements over the interpretation of performance metrics as achieving earnout targets may be influenced by factors beyond the seller’s control. Therefore, a combination of metrics, such as profit and revenue, are often used to balance out the interests of both parties.
Given the complexities involved with earnout, many buyers and sellers enlist the services of experienced legal and financial advisors, as well as M&A advisors, to advise and represent them throughout the process so that potentially damaging disputes can be avoided.
7 steps to structure an earnout
Structuring an earnout is best achieved when broken down into several key stages. From purchase price to performance metrics, here’s how to structure an effective earnout.
1. Determine the total/headline purchase price
Start by calculating the total amount to be received by the seller. The will more than likely be a commonly agreed figure based on the seller’s asking price and what the buyer is willing to pay. In some cases the buyer will offer to bridge the full valuation gap allowing the seller to realise the full purchase price. If the buyer is unwilling to bridge the valuation gap they may try and set the total purchase price at a lower rate, say 75% of the seller’s asking price.
2. Agree an upfront payment
Next, determine how much of the total purchase price will be paid on completion of the deal. This upfront payment should be equal to the buyer’s enterprise valuation. It also represents any at-risk capital that will be written off should the business underperform and equate to less than the upfront payment.
3. Calculate a contingent payment
A contingent payment – the total purchase price minus the upfront payment – should be determined at this stage.
4. Establish an earnout period
It’s vital that the buyer and seller agree on the length of the earnout period. The average earnout period is three years, though it can stretch to five years and sometimes longer. Essentially, the earnout period should be long enough for managers to achieve their goals, but not so long that it causes operational difficulties.
5. Determine performance metrics
Metrics are a key factor when evaluating business performance. These performance metrics should be clearly defined, measurable, and agreed by both buyer and seller. Performance metrics are twofold: financial and operational.
- Financial metrics are generally revenue or profit based. Revenue is applied when it becomes difficult to measure specific profit profile. Profit metrics such as EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) are used when a target business continues to operate as a stand-alone subsidiary.
- Operational metrics, however, are commonly measured in milestones. They are often found in technology or pharmaceutical companies where the development of new products can have a significant increase the estimated value of the business.
6. Measurement and payment methodology
Two options for measurement and payment are generally applied in an earnout structure. The first is multiple, staged measurements and payments, whether annually or more frequently. The second is a single measurement and payment, generally at the end of the earnout period. At this stage, the method used for measurement must be determined. This is mostly based on two concepts – (a) financial growth between the acquisition date and the end of the earnout periods, and (b) an absolute value target that’s achievable between the acquisition date and earnout end date.
7. Target/threshold and contingent payment
The final step in the structure is to determine the target metric (performance level) and how this aligns with earnout payments for achieving that performance level. This involves a balance of risk and reward, where the structure allows for rewards for partial performance by the target company even though it may fall short of its performance goals.
What are the advantages of an earnout in M&A?
An earnout is particularly beneficial for the buyer of a business. It gives them more time to complete the transaction than having to pay for everything upfront. Also, if business revenue turns out to be lower than anticipated, the buyer won’t have to pay as much. Not only that, but an earnout means the total price paid for the acquisition can be based on the seller’s future performance rather than a projected or estimated performance, thus minimizing the risk of the buyer overpaying.
The seller of a business also benefits from an earnout, with one of the chief advantages being the ability to spread out tax payments over several years. This helps ease the impact taxes may have on the sale and increase the chances of a successful deal.
Overall, earnouts are useful tool in M&A transactions as they provide flexibility over the structure of a deal, while providing sellers with a means for realizing additional, post-acquisition value if the business performs well and above expectations.
What are the disadvantages of an earnout in M&A?
There are potential disadvantages to an earnout. For the buyer, it could be that the seller continues to be involved in the business and tries to influence the day-to-day running for an extended period of time. While their previous experience no doubt has value, their input post-acquisition could give rise to disputes with the buyer and create disharmony in the workplace.
Meanwhile, the seller could also be at a disadvantage if the future earnings of the business fall short of financial predictions set out in the earnout. If this happens, the seller won’t make as much from the sale of the business as they might have expected.
Ultimately, all parties involved in M&A should approach earnouts with great care and consideration and ensure detailed documentation is in place to mitigate potential conflicts and disputes.
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