Earnouts – Things to Be Mindful Of
Background
In the world of mergers and acquisitions (M&A), earnouts have become increasingly popular as a means of bridging the valuation gap between buyers and sellers. An earnout is a contractual provision in an acquisition deal that links part of the purchase price to the performance of the acquired business post-acquisition. While earnouts can be beneficial for both parties, they also come with their fair share of risks. In this blog, we will explore the concept of earnouts, highlight potential pitfalls, and provide valuable insights on how to protect yourself and your interests in such arrangements.
Understanding Earnouts
Earnouts are structured to ensure that the seller receives additional consideration if certain pre-defined performance metrics are met within a specified period after the acquisition. These metrics are typically financial-based, such as revenue targets, profitability, or customer retention rates. Earnouts are often employed when there is uncertainty about the future performance of the acquired business or when there are divergent views on its valuation.
The Appeal of Earnouts
For sellers, earnouts present an opportunity to realize the full potential of their business and share in its future success. It allows them to demonstrate the value of their company, which might be difficult to assess at the time of closing or not be immediately apparent to the buyer. On the other hand, buyers see earnouts as a way to mitigate risk, as they only pay the additional amount if the business performs as expected. Additionally, buyers view earnouts as a tool that is highly effective at incentivizing and retaining management post-close as there are monetary rewards for the achievement of performance metrics that are beneficial to the business.
Potential Risks and Challenges
While earnouts can be a win-win scenario, they are not without risks. One significant challenge lies in defining the earnout metrics. Both parties may have different perspectives on what constitutes fair, controllable, and achievable goals. This can lead to disputes and even legal battles if the expectations are not met.
Moreover, external factors, such as changes in market conditions or industry trends, may significantly impact the performance of the acquired business during the earnout period. In such cases, the seller may be left disappointed with the earnout amount received. These challenges, along with other important considerations, are explored further in the following section.
Protecting Your Interests
To safeguard your interests when considering an earnout, it is crucial to follow these essential steps:
Negotiate Clear and Realistic Metrics: Ensure that the earnout metrics are unambiguous, measurable, and reflect the true potential of the business. Work collaboratively with the acquirer to set realistic targets that are achievable and controllable, even in challenging market conditions. As a general rule for financial-based earnouts, as the earnout metric falls further down the income statement (i.e., revenue, gross profit, EBITDA, etc.) both controllability and measurability become increasingly difficult.
Define the Timeframe Thoughtfully: Agree on a reasonable timeframe for the earnout period. Too short a duration might not allow sufficient time for the business to show its true potential and achieve said performance metrics, while an overly extended timeframe could lead to increased uncertainty and hinder the seller's financial planning. We typically see earnout periods lasting between one to three years.
Monitor Performance and Communication: Regularly monitor the performance of the acquired business and maintain open communication between the buyer and seller. Transparent communication and a recurring review cadence can help identify potential issues early on and foster a spirit of collaboration.
Address Potential Conflicts: Establish a mechanism to resolve disputes that may arise during the earnout period. Consider including an arbitration clause in the contract to prevent costly and time-consuming legal battles. Hiring legal counsel with extensive M&A experience can help to ensure that such language and other crucially important earnout considerations are fully captured in the acquisition’s definitive documentation.
Consider Alternative Structures: Macroeconomic uncertainty, changing industry dynamics, and lack of control and oversight in the pro forma entity are some of the reasons why a seller might perceive an earnout structure to be too risky or complex. If this is the case, the seller has the option of exploring other deal structures that may offer a more straightforward approach. Alternative structures include staged buyouts, milestone payments, performance bonuses, and equity rollovers.
Conclusion
In summary, earnouts can be a valuable tool in M&A deals, aligning the interests of both sellers and buyers and providing sellers a path to unlock additional value of the acquired business. However, earnouts require careful consideration, clear communication, and thorough negotiation to ensure a successful outcome. By being mindful of the potential risks and taking steps to protect interests, sellers can navigate earnout agreements with confidence and increase the likelihood of a mutually beneficial acquisition experience. It is always important to consult with experienced legal and financial advisors to craft an earnout agreement that considers these topics as well as captures any unique needs and circumstances as earnouts are far from being one size fits all.