Corporate Finance Advisors
After more than 25 years working on M&A transactions, first as a corporate tax and M&A lawyer and now as an M&A advisor, I have seen many deals where Buyer and Seller agree on almost everything, except what the business is worth.
The Seller looks at the company's history, its growth opportunities and what the business could earn over the next several years.
The Buyer looks at many of the same opportunities but asks a different question: What if those future earnings don't materialize?
An earnout can sometimes bridge that gap.
Rather than requiring the Buyer to pay the entire purchase price at closing, part of the consideration becomes payable after closing if the business achieves agreed financial or operational targets.
In the right circumstances, an earnout can be an effective tool for getting a transaction completed.
But earnouts also create something unusual in an M&A transaction: the Seller's ultimate purchase price may depend upon what happens to the business after the Seller no longer controls it.
That is where things can get complicated.
An earnout is a form of contingent purchase consideration.
Assume a Seller believes the business is worth $12 million, while the Buyer is only prepared to pay $10 million based upon the company's current financial performance.
Instead of allowing the $2 million valuation gap to kill the transaction, the parties might agree to:
If those targets are achieved, the Seller receives some or all of the additional consideration.
If they are not, the Buyer pays less.
Conceptually, the arrangement is straightforward.
In practice, however, the important question is not simply how much the earnout could pay. It is what has to happen for the Seller to actually receive it.
Earnouts can solve several legitimate transaction problems.
Perhaps the company has recently experienced rapid growth and the Seller believes that growth should be reflected in today's valuation.
Perhaps a major new customer has been signed, but the financial results have not yet appeared in the historical statements.
Perhaps the Seller has forecast significant growth that the Buyer believes is possible but is unwilling to pay for upfront.
Or perhaps the parties simply have different views about sustainable EBITDA.
An earnout allows the parties to effectively say: If the future performance occurs, the Seller will be paid for it.
From the Buyer's perspective, this reduces the risk of paying today for earnings that may never materialize.
From the Seller's perspective, it provides an opportunity to receive additional value if the business performs as expected.
That can be a sensible compromise. But only if the parties carefully define the rules.
One of the first questions is what will determine whether the earnout has been achieved:
Each of the above-noted metrics create their own different incentives and risks.
For instance, “revenue” may appear relatively straightforward, but revenue alone says nothing about profitability. A Buyer could theoretically increase sales dramatically while generating very little incremental profit.
EBITDA, on the other hand, may better reflect profitability, but it introduces considerably more judgment. What expenses will be included? How will corporate overhead be allocated? What happens if the Buyer hires additional employees? What if compensation changes? How are related-party charges treated? What happens if the Buyer makes significant investments in marketing, technology or expansion during the earnout period? If the earnout is based on adjusted EBITDA, which adjustments are permitted?
The more judgment involved in calculating the metric, the greater the potential for disagreement.
In my view, this is one of the most important issues for sellers to understand and a key reason why earnout definitions are often among the most heavily negotiated provisions in an M&A transaction.
Before closing, the Seller controls the business. After closing, the Buyer generally does.
Yet the Seller may still have hundreds of thousands, or even millions, of dollars of purchase price dependent upon their former company's post-closing performance.
Consider a Seller entitled to a $1 million earnout if EBITDA reaches $2 million during the following year.
After Closing, the Buyer decides to hire several senior executives, substantially increase marketing expenditures, integrate the company with another business, change suppliers, discontinue a profitable product, reallocate customers, charge new management fees, or accelerate expenditures that might otherwise have occurred in a later period.
Some of those decisions may be entirely reasonable from the Buyer's long-term perspective. But they may also reduce EBITDA during the earnout period.
The parties therefore need to think carefully about the tension between two legitimate objectives: the Buyer needs reasonable freedom to operate the business it has purchased, while the Seller needs reasonable protection against actions that could unfairly undermine the earnout.
Getting that balance right is one of the central challenges in negotiating an earnout.
In Part 1 of this series, I discussed how definitions can materially affect a working capital adjustment. The same lesson applies to earnouts.
Suppose an agreement says the Seller will receive an additional $500,000 if the company achieves $2 million of EBITDA. That sounds clear, right… it may not be.
Which accounting principles apply? Are accounting policies required to remain consistent with historical practices? How are extraordinary or non-recurring expenses treated? Are acquisition-related costs included? What happens to management fees charged by the Buyer or an affiliated company? How are shared employees or centralized expenses allocated? Can the Buyer change the company's fiscal year? How are revenues and expenses arising from a post-closing acquisition treated?
The purchase agreement should answer as many of these questions as reasonably possible before closing.
A detailed schedule illustrating the earnout calculation can often be extremely helpful.
The objective is the same as with working capital: reduce the ability of either party to reinterpret the economics of the transaction after closing.
Earnouts can also create unintended cliff effects.
Suppose the Seller receives $1 million if EBITDA reaches $2 million, but nothing if EBITDA is $1.99 million.
That means a relatively small difference in financial performance could produce a $1 million difference in purchase price.
Depending upon the transaction, the parties may instead consider a graduated or proportional earnout.
For example, the Seller might begin earning additional consideration once EBITDA exceeds an agreed threshold, with the payment increasing as performance improves up to a specified cap.
There is no universally correct structure. The important point is to model the possible outcomes before agreeing to the formula.
The Seller should understand what happens if performance is slightly below target, at target, or significantly above target. If those answers produce commercially unreasonable results, the formula may need more work.
Another important issue is whether the Seller will remain involved in the business during the earnout period.
Sometimes that makes considerable sense. The Seller may have important customer relationships, industry knowledge or operational expertise that will help achieve the earnout targets.
But this can also blur two separate relationships: the Seller may simultaneously be the former shareholder entitled to contingent purchase consideration and an employee, consultant or executive working for the Buyer.
The transaction documents should contemplate what happens if that relationship ends.
What happens to the earnout if the Seller resigns? What if the Buyer terminates the Seller without cause? What if the Seller becomes ill or is otherwise unable to continue? Does termination affect the earnout at all? Could some or all of the earnout accelerate?
These are issues that are much easier to negotiate while everyone still wants to complete the transaction than after the relationship has deteriorated.
Earnouts should generally be long enough to measure the performance the parties are actually trying to test.
But extending an earnout for too long can create its own problems.
Businesses change. Markets change. Management teams change. Buyers integrate acquisitions. Strategies evolve.
The longer the earnout period, the more difficult it may become to distinguish between the performance of the business the Seller sold and the consequences of decisions made by the Buyer after closing.
That is another reason why earnout periods, metrics and operating covenants should be tailored to the particular transaction rather than simply copied from another deal.
Like a working capital adjustment, the mechanics for determining the earnout should be clearly established in the purchase agreement.
The purchase agreement should generally address matters such as:
Where the earnout depends upon accounting calculations, unresolved disputes may ultimately be referred to an independent accountant in the capacity specified by the agreement.
Again, the objective should not be to create a roadmap for litigation. It should be to establish a sufficiently clear process that litigation becomes less likely.
Business owners sometimes focus primarily on the maximum possible transaction value.
A proposal might be described as a $15 million offer. But if the structure is $10 million at closing, $2 million of vendor financing, and up to $3 million through an earnout, that is economically very different from receiving $15 million in cash at closing.
The Seller should understand not only the headline number, but also: How much is certain? How much is deferred? How much is at risk? What has to happen for the contingent amount to be paid? Who controls whether those conditions can realistically be achieved?
Those questions go directly to the economics of the transaction.
An earnout can be an excellent M&A tool.
It can bridge legitimate differences in valuation, allow a Seller to participate in future performance and give a Buyer greater confidence that it is paying for earnings that actually materialize.
But an earnout should not simply postpone a difficult valuation discussion.
Before agreeing to one, both parties should understand exactly what disagreement they are trying to solve.
Is the issue uncertainty about future revenue? Sustainable EBITDA? Customer retention? A new contract? Management transition? Growth projections?
Once the underlying issue is identified, the earnout can be designed around that risk.
My experience over more than 25 years of M&A transactions has reinforced another simple lesson: If an earnout matters to the economics of the deal, negotiate it as carefully as the purchase price itself.
Define the metric. Model the outcomes. Understand who controls the business. Establish appropriate protections. Determine how the calculation will be made. And agree upon a clear dispute-resolution mechanism before the transaction closes.
A successful earnout should help bridge a valuation gap. It should not create the next dispute.
At Minerva Valuations, our objective when advising Sellers is to maximize the amount of purchase price received at closing and minimize unnecessary post-closing financial and legal risk. In transactions we have advised on, we have been able to structure deals with approximately 80% to 95% of the purchase price payable at closing, reducing the amount of the Seller’s proceeds left subject to earnouts, vendor financing or other post-closing contingencies.
Our M&A Advisory team works with business owners throughout the transaction process, from understanding value and preparing a business for market through transaction structuring, buyer negotiations, due diligence and closing.
If you are considering buying or selling a business and would like to understand how an earnout or other deal terms could affect the economics of a transaction, we would be pleased to have a confidential conversation.
This is Part 2 of my three-part M&A Deal Economics series. In Part 3, I will look at Asset Sale vs. Share Sale: Why Structure Can Matter as Much as Price.
