Your Complete Guide to Earnouts
June's four part series on M&A negotiations at tech startups
Welcome back to Part III in our month long series on M&A Negotiations. So far we’ve covered Liquidation Preferences and Accelerated Vesting. This week we cover the art and science of Earnouts.
Earnouts, AKA “getting paid later”, are a variable component to an acquisition’s purchase price.
These arrangements help buyer and seller bridge the gap between each side’s perceived valuation, while putting guardrails in place to safeguard the buyer against certain risks. Earnouts essentially ask the seller to “prove” a component of their worth.
Said another way, the earnout is often funded in part by the performance of the seller’s business. So it kinda pays for itself. Plus, there’s less risk of overpaying for a business
While earn outs force the seller to take some risk on behalf of the buyer, and effectively use their now-acquired business to earn the full purchase price, hopefully they also get an opportunity to achieve some upside.
So with that 40,000 foot view, let’s “earn” our keep:
What Types of Risks is the Buyer Hedging?
Types of risk the buyer is hedging against:
Ensuring key employees keep their heads “in the game” and performing after receiving a whack of cash
"It's hard to wake up and do road work at 5:00 am if you're sleeping in silk pajamas."
-Marvin Hagler, Middleweight Champion
Closing important in-flight deals (like a big enterprise agreement or government contract)
Retaining key customers upon renewal
Finishing key products
Common Lengths
Typically one to three years. I’ve seen five years on the higher side, but at that point it’s more like indentured servitude.
How Big?
Cash upon closing usually represents between 70% and 80% of the transaction value, while earnouts and escrows represent the remaining 20% to 30% of the purchase price.
That means the seller gets 70% to 80% of the "total consideration” in cash upon closing, and then is incentivized to stick around and ensure the business continues to execute to get the remaining 20% to 30%.
(Note: There are always exceptions… earnouts can be as high as 50% of the purchase price (Morgan and Westfield).)
How Often?
According to Harvard Law, in 2023 about 37% of M&A deals included an earnout. This compared to 43% of such deals in 2022, 33% in 2021, and 36% in 2020.
Prior to these pandemic-affected years, the historic rate was roughly in the range of 20-30%; and, in 2019 and 2018 (the two years just before the pandemic), the rate of usage was about 20%.
“Current usage of earnouts remains above the historic, pre-pandemic rate” - Harvard Law
This makes sense. There’s more doubt about valuation in tougher economic climates. And it becomes a buyer’s market where they will want to put protections on deals if they can.
Plus, earnouts may allow a company to preserve a headline valuation they previously achieved by adding some milestone targets.
Private vs Public
Earnouts are way more prevalent in private company transactions than public. This is because private companies tend to have more “grey areas” within their books, and their longer term performance may not be proven.
Think of a tech company with only two years of sales history and no audits - you might want to hedge those bets.
(Paid readers who support my work will get smarter on: Inherent Frictions to Solve For, Agreeing on Metrics and Measurements, Escrows vs Earnouts, and Aligning Incentives)
Inherent Frictions to Solve for
Generally speaking, sellers view revenue goals more favorably than earnings goals, as they have more control over the latter once they step into the business.
And buyers generally prefer earnings goals, as they are a better proxy for deal value.
Some frictions that commonly arise include: