Has a buyer made you an offer that includes an earnout?
Valuation and deal structure are key in achieving a successful M&A transaction. To bridge potential differences in valuation expectations between seller and buyer, and to position the company for strategic growth in the near future, the deal structure may include earnout provisions. In an earnout, part of the purchase price is paid to the seller at a specified future date after the closing, based upon the company achieving specific performance goals.
While earnouts are most commonly employed when there is a gap between what the buyer is willing to pay and what the owner believes the business is worth, they are also used to share in the potential risk of future (albeit short-term) growth that can’t be easily accounted for by using a simple EBITDA multiple. In essence, an earnout allows the buyer to mitigate risk while positioning the seller to benefit from company growth after the sale closes, and receive payment if/when the company achieves specific goals.
Deal negotiations are typically spirited, and deal structure often complex. Earnout negotiations can put new partners at odds with one another if the earnout structure is difficult to measure, or if the likelihood of success is diminished because growth objectives for the company over the next year or two change and negatively affect an owner’s ability to achieve the earnout. Navigating this terrain requires a managed process and tenured banker experience to avoid a potential deal derailment. Professional expertise can help a business owner avoid costly mistakes and ensure their deal structure is reasonable, achievable and fair.
Even when working with an investment bank, it is prudent as an owner to remain attentive to these four criteria:
- Keep it simple – Earnouts should not be linked to complex financial models. They should be based upon easy-to-understand goals such as: sales revenue, EBITDA targets, new customers secured, or other reasonable and easy to measure targets. This makes it easy to determine whether the objective has been met, and helps eliminate the chance that either party will later feel taken advantage of in the new partnership.
- Confined to a reasonable length of time – Many owners accept that they will be required to roll over some equity and stay actively engaged in their company after they sell. However, part of their rationale for selling the company was to have the opportunity to diversify their assets and pursue other activities. Therefore, earnout timelines should be focused on the near-term performance of the company over a period of one to two years. Some earnouts are structured to allow the owners to reduce their level of involvement in the company over time to allow them more personal and business flexibility.
- Realistically attainable – The ultimate value of the company should be based upon reasonable growth projections founded on both historical and projected growth. Earnout provisions should also be linked to objectives that are reasonable and attainable. This will protect the owner and provide a reasonable opportunity to complete the earnout as expected. Too often earnout provisions are not clearly structured and include unrealistic timelines. This can create confusion as to what is being measured and for how long, thereby making it all but impossible for the owner to earn the money outlined in the sales agreement.
- Get as much “cake” as possible – Your business is worth a certain value today. You should be paid that value when the deal closes and that value should not include an earnout. Cash is cake; contingent payments, like earnouts, are frosting. With the assistance of an experienced investment banker, owners can secure as much cash (cake) as possible when the deal closes, with the earnout as frosting on the deal, not a major percentage of the transaction. Far too often, owners accept deals with lots of frosting and very little cake. When you sell, negotiate for a Bundt cake – where a thin layer of icing is drizzled on top!
While structuring and managing earnouts can be difficult, in some cases it is the most effective tool (and might be the only way) to bridge the valuation gap between the buyer and seller. Skillful negotiation is the key to achieving proper deal structure and obtaining full valuation. Owners should remember that cash is king, and earnouts play a secondary role in helping close the deal.
About the Author
David J. Mahmood
Chairman & Founder
Phone: (214) 217-7732