What is an Earnout in M&A
By: Jack Schanze
Buyers and sellers can deploy a myriad of creative methods in a deal structure to help finalize negotiations and get a deal across the finish line. Buyers can utilize mechanisms that alter the amount of cash the seller receives at the time of closing in exchange for something like a seller note, “rolled” equity, stock awards or an earnout. These creative approaches are most often leveraged in situations such as to help bridge the difference in the buyer’s and seller’s perceived value of the business, when the seller’s industry is volatile or expects headwinds in the future, or in a general time of economic uncertainty. The focus of this article will be to understand earnouts, why they are used and how they can benefit both the buyer and the seller in the right situations.
An earnout is a contingent payment, or contingent series of payments, that the seller receives once it meets or exceeds a predetermined financial target that was agreed upon at the closing of the transaction.
Earnouts are almost always tricky to negotiate as buyers and sellers not only tend to have differing viewpoints on the structure, but also whether to utilize an earnout at all. Opposing views on the timing and structure of an earnout, the financial metric(s) that the earnout is based on, and how the total Enterprise Value (“EV”, defined as the total fair market value of a business, calculated as Equity Value + Debt - Cash) is split between cash at close of the transaction and contingent payment can all lead to difficulty in negotiations. Ultimately, getting a buyer and seller to agree on an earnout requires thoughtful, honest discussion and a deep level of trust between both parties.
Overview of Common Earnout Structures
All or Nothing
The seller receives either all or none of the earnout if it meets a predetermined milestone.
Example: The buyer will pay the seller $10 million if revenue exceeds $100 million in the first year after the sale.
If the company achieves $120 million in sales, the seller receives $10 million. If it reaches $99 million or less in sales, the seller receives nothing.
Note: This earnout structure is becoming less common if the milestone is based on a financial metric. It is more useful if the milestone is based on a non-financial metric, such as a pharmaceutical drug manufacturer receiving FDA approval.
The seller receives a multiple of a dollar figure based on predetermined criteria.
Example: The buyer will pay the seller a 5x multiple of any EBITDA earned that exceeds $10 million in the first year after the sale.
If the company’s EBITDA does not exceed $10 million, the seller receives nothing. If the company achieves $12 million in EBITDA, the seller will receive $10 million ($2 million * 5). If the company achieves $15 million in EBITDA, the seller will receive $25 million ($5 million * 5).
Note: This structure is more commonly used due to the inherent alignment of both the buyer’s and seller’s goals.
If an earnout provision is built into an acquisition, this helps protect the buyer from downside risk if the asset does not perform well post-acquisition, reducing the probability of overpaying if expected returns are not realized. Earnouts also allow the buyer to participate in future upside if the company does perform well. It serves as a retention tool for key personnel within the business and incentivizes strong performance post-acquisition. Earnouts help align the buyer’s post-transaction goals with the seller’s and force the seller to “earn” the full Enterprise Value that was agreed upon at the time of sale.
Most sellers prefer to avoid an earnout and would rather receive 100% cash at the time of closing. Consider business owners that are pursuing a sale to retire: it will be challenging to retire at the time of sale if a chunk of the purchase price is tied up in an earnout that requires several years of participation post-sale. Other owners that still have runway left may want to avoid an earnout to mitigate the risk of collecting future payments and using its own balance sheet to pay for EV. How does the seller know that new ownership will provide the support, resources, and operational freedom to execute on its plan to receive the earnout? Will new ownership change financial reporting or accounting policies that negatively impact the seller’s performance or manipulate a key metric that determines the value of the earnout?
On the flip side, some sellers may prefer to have an earnout provision. Consider the seller has no plans of retiring soon and wants to continue working within the business. The seller believes in the growth potential of the business and trusts that the buyer is the right partner to help unlock that potential. Knowing an earnout can serve as a means to increase the overall Enterprise Value, since a buyer would likely be willing to pay more for an asset if a portion of the purchase price is contingent upon future performance, the seller may want to negotiate an earnout to have a chance at a larger payout.
In Closing …
As mentioned above, it is not an easy task to get a buyer and seller to agree on an earnout. Sellers must beware of buyers’ post-sale intentions and carefully consider the risks associated with entering into an earnout agreement. The seller should ensure it has the appropriate protections built into the purchase agreement to help prevent any manipulation and minimize future disputes. Leveraging the expertise of experienced investment bankers and transaction attorneys can help smooth negotiations and assist the seller in receiving a desirable outcome. In the end, successful earnouts are achieved when the buyer and seller are in a true partnership and goals are aligned to generate the best possible future for the business.