Earnouts: Bridging the transaction gap

Clear and accurate structure and deal terms are key components of a successful merger and acquisition (M&A) transaction. While many transactions are deemed ‘clean,’ as they are based upon an all-cash (100 percent) deal, there are other transactions where cash, plus a vendor note and / or an earnout, are components of the consideration.

A common feature of many M&As, an earnout is a provision where the seller of a business receives additional payments in the future if certain financial goals are met, post sale. At a high level, the intent of an earnout is to bridge the valuation gap between the seller’s expectations and what a buyer is willing to pay. Earnouts can mitigate the buyer’s risk while enabling the seller to participate in future profits.

Negatives to Earnouts

Earnouts may play a role in helping close a deal, but are not the right solution for every transaction. Some sellers will not consider an earnout of any form, as they will have lost operational control of the company once it has been sold. Also, earnouts can be litigious if they are not properly understood and documented.

Sellers tend to shy away from earnouts, and generally have the same sentiment: Cash is King!

Positives to Earnouts

On the flip side, most buyers prefer earnouts, as it allows them to conserve cash at closing and protects them from overpaying.

Earnouts can be viewed as a ‘cherry on top’ to a seller if they receive their target price in cash on closing, with an opportunity to earn more. Also, earnouts can be viewed as a good signal to the buyer and financiers as the sellers are willing to put a portion of their proceeds at risk with the new buyer.

Each Earnout Unique and Subject to Negotiation

Each Earnout Unique and Subject to Negotiation Typically, an earnout is utilized in a scenario where a seller believes that the earnings of the business will grow at a certain level, and the buyer is willing to pay a portion of the price in cash on closing and pay the remainder over time if certain performance targets are met.

A Simple Example: Last year, Company ABC generated $10 million in revenue and $1 million in EBITDA (earnings before interest, taxes, depreciation and amortization). ABC has generated 10 percent revenue and EBITDA growth for the past 5 years, and is expecting to maintain this pace for the next 5 years and beyond due to a number of factors including high quality customers and an overall good outlook in its industry.

Buyer X has valued ABC at a multiple of 6 times last year’s EBITDA of $1 million, equating to an enterprise value of $6 million.

The shareholders of ABC believe that the company is worth 6 times the future maintainable level of EBITDA of $1.5 million, equating to an enterprise value of $9 million.

There is a value gap of $3 million… Here is where the earnout can bridge this gap.

The Transaction: Buyer X agrees to pay $6 million cash on closing, and will share 50 percent of future EBITDA above $1 million for 5 years. Buyer X believes that they have paid fair market value based on what the company is currently generating, and is willing to share a portion of the future earnings of the business.

Buyer X is not willing to share all profits above $1 million of EBITDA for a number of reasons, including the efforts they will input to achieve these results and the potential for additional expenses (hiring employees, marketing expenses, capital expenditures, etc.)

For every dollar that ABC generates EBITDA above $1 million, the former shareholders of ABC will earn 50 cents for 5 years.

Setting a Target

Performance targets for an earnout are usually financial targets and can vary broadly based upon factors including: the amount of cash consideration paid on closing as a percentage of the overall transaction price; the strength and consistency of the company’s historical results; and the competitiveness of the transaction (i.e., how many buyers are pursuing the opportunity).

The length of an earnout period commonly ranges from one to five years following the transaction date.

It is important to define the performance target, preferably at the letter of intent stage, but certainly in the purchase and sale agreement. It is much easier to take the time to properly define and understand the earnout in advance, as compared to fighting about it in court after one or two years.

There are many earnout performance targets. The farther down the income statement, the more susceptible the results can be to accounting policies and manipulation. Buyers prefer to measure performance based on EBITDA or free cash flow, while sellers desire top-line targets such as revenue or gross profit.

Examples of performance targets

Revenue target:

• The company is to meet certain revenue targets over a defined time period. The concept is that the profitability should be similar / comparable to historical levels, thus, revenue should be a reasonable benchmark.
• The vendors do not have control over how the company is operated, but may be comfortable a certain level of revenue will be met.
• Revenue is the easiest to understand and hardest to manipulate.

Gross profit target:

• The company is to meet certain gross profit targets over a defined time period. By moving lower in the income statement, this helps ensure revenue is generating similar profits for the company.
• Gross profit is the next simplest form of earnout after the revenue target and is subject to less debate about its calculation.

EBITDA target:

• The company is to meet certain EBITDA targets over a defined time period. Most private company transactions are valued and transact based upon a level of EBITDA, thus, EBITDA targets are quite common in earnout scenarios.
• It is important certain operational and discretionary expenses, such as salaries to the new buyers (and perhaps family members) are defined and quantified as much as possible.
• If EBITDA is not properly defined, the buyer could inflate salaries and bonus amounts to lower the EBITDA.

Free Cash Flow target:

• The company is to meet certain free cash flow targets over a defined time period. This target generally favours the buyer, as it considers cash taxes, capital expenditures and debt repayments.
• This type of earnout can be seen with start-ups; companies with highly volatile revenue and earnings; and transactions that are not competitive.

Other considerations when drafting an earnout include (but are not limited to):

Payment Frequency: Earnout payments can be made annually – a few months following the company’s year-end or at the end of the earnout period, if an average financial target is used in the earnout benchmark.

Payment Limits and Shortfalls: The earnout payment may be defined based on an annual test of meeting a financial target, or may be based upon an aggregate amount over the earnout period. Further, earnout payments may be subject to annual limits, but have the ability to ‘catch up’ in future periods. For example, an earnout might have a limit of $1,000,000 consisting of five annual payments of no more than $200,000 each, with shortfalls subject to ‘catch up.’ In this situation, if an annual earnout payment were calculated as $150,000, subsequent annual payments may exceed $200,000 until the $50,000 shortfall has been erased.

Review Earnout Calculations: The financial statements are typically reviewed or audited by an external accounting firm to provide a level of comfort and diligence to the seller. The seller commonly has the right to review the financial records of the company to ensure the earnout target has been properly calculated and accounted for. The accounting policies and practices should be consistently applied for purposes of calculating the earnout metric.

Change of control provisions: To protect the seller from losing their rights to an earnout in the event of the buyer selling the business within the earnout period, the seller typically requests the earnout provision or obligation remain with the new owners.

Security: To protect the seller and to put ‘teeth’ into the earnout in the event of a dispute, there may be various forms of security involved, including hypothecation of shares, a charge on some assets, a second charge on assets, or a personal guarantee of the new shareholders.

Close the Deal with Confidence: Get Expert Advice

Deal negotiations can be a very emotional process, and deal structures can become quite complex. It is important to ensure that if an earnout is utilized in a transaction, it is clearly understood and effectively communicated by both buyer and seller. Hiring a tenured M&A advisor and transaction lawyer on both sides of the transaction can help to effectively navigate and manage the process to ensure a successful transaction for both parties.

For more information, contact Craig Maloney, Managing Director Corporate Finance, at 902.835.7333 or [email protected]