Using Earnouts to Bridge Valuation Gaps in Uncertain Times

The use of an earnout is one mechanism buyers and sellers of private businesses can use to simultaneously satisfy both parties differing viewpoints on business value during an M&A negotiation.  While most sellers would prefer an “all-cash” deal, buyers often remain skeptical of the sellers’ projections, particularly when there are a lot of market uncertainties.  The earnout can help mitigate those concerns but can also raise other issues that sellers need to be cognizant of, and as such, requires careful consideration.

According to data supplied by  SRS Acquiom on more than 1200 private company transactions between 2016 and 2019, 27% of the deals included an earn-out provision, when the deal size was less than $50 million.  When the technology and life-science industries were excluded, it drops to 19%.  Almost all earnouts had a cap (97%), and 80% were for three years or less. More than half (53%) were based on revenue, while 33% were based on EBITDA or some other earnings metric.  Forty percent were based on some other milestone metric or a combination of financial and milestone metrics.

The earnout is inherently risky for the seller for the simple fact that they have given up control of the business, and therefore may or may not be involved in key decisions that could impact the payout of the earnout.  The buyer’s priorities often change as they begin to operate the new business and decisions on funding new hires, marketing, new product development, capital expenditures, etc. also change.  While many “resource provisions” can be included in the earnout agreement, market conditions, such as a global pandemic, may require a business to pivot from its plan, and force a business to re-think its allocation of resources.  It is doubtful that pre-2020 deals with existing earnouts included provisions for a pandemic, yet it is reasonable to assume that many may not be paid out as a result.  It will be interesting to see whether the pandemic leads to an increase in disputes that need to be settled through arbitration or worse, litigation.
There are generally two broad categories of earnout payout provisions: Those based on financial metrics and those that are based on non-financial metrics.

Financial metrics include items such as EBITDA, revenue or some combination of financial metrics.   Generally, sellers prefer revenue as they can have little control over operating expenses.  Buyers are often concerned about using revenue as a metric, as new sales may not be very profitable, and therefore prefer some type of earnings metric.  There can also be disputes on how financial metrics are calculated so it is critical to have this clearly defined upfront.  An adjusted EBITDA metric is one option often used, whereby the line items used to make the adjustments are defined beforehand, or it is based on a baseline EBITDA amount or percentage.  One best practice is to include an example calculation in the agreement itself.  Complex earnouts that rely on accounting standards, assumption on expense exclusions/inclusions etc. can be a dispute waiting to happen.

Non-financial metrics can sometimes be simpler to use and less subject to dispute.  For example, a business may be worth a lot more to the buyer, if a contract with a large customer is renewed.  Perhaps the seller can have a significant influence on whether it is renewed, after the business has been sold, and can mitigate concerns a customer may have with management under new ownership.  On the flip side, the buyer may be concerned that conditions of the renewal may not be acceptable, while the seller may be concerned that the new owner is not aggressive enough on pricing.

While good data on the probability of a payout is hard to find, there are certainly lots of anecdotal stories of where the full earnout was not paid.   The key for both parties is have the provisions clearly defined, ensure that dispute mechanisms are fair and specific to the earnout and to keep them simple and easy to calculate wherever possible.
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Given the current M&A environment from the pandemic, earnout provisions are likely to be for longer terms and likely to become a larger part of the total consideration.  The use of an earnout to bridge a valuation gap can benefit both the seller and the buyer when structured properly.  The buyer reduces the risk they will be paying for results that never materialize, and the seller can potentially find a path to meet their full valuation expectations. Undoubtedly, both the legal and tax implications can be complicated and material to both the seller and the buyer, so caution and thoughtfulness are a prerequisite for both parties.

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