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.
Example of a 4 year earn out
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.
(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:
“I don’t have control over the P&L, how do you expect me to control my costs?”
“You are telling me to sell the product one way, when I think the way I’ve always done it is better”
“Why are you giving away my product for a song to get users for your existing product?”
“Why do I have to pay for corporate overhead? It’s dragging my numbers down.”
Agreeing on Measurement and Metrics
The Share Purchase Agreement (SPA) defines the metric(s) used to calculate the earnout. An earnout is typically paid in cash to sellers following the end of the relevant period if the metric is achieved but may, sometimes, be paid by way of shares in the parent company (BDO UK).
And memories tend to get fuzzy post-closing, so it’s crucial to define the metrics you assign targets to clearly. Some metrics may include:
Revenue $’s
Revenue % growth
EBITDA $’s
EBITDA % growth
EBITDA % margin
New customers acquired #
New users acquired # (think: social network)
User growth %
Moreover, external factors such as economic downturns or industry-specific issues can affect performance, making it harder for the seller to achieve the earnout conditions. Both parties must carefully consider and address these risks during the negotiation process. A practical approach is to include a third-party auditor to verify performance metrics and reduce the risk of disputes.
I can’t overstate this enough: When drafting an earnout agreement, specify the exact metrics and the methods of calculation to prevent any ambiguity.
Adjusted EBITDA is a very common metric to use as an earnout’s north star. But, as the term implies, “adjusted” can mean a lot of different things.
“Once a buyer controls the business, they may want to use their own accounting policies to prepare the relevant accounts for the earnout. The seller should try to ensure that the same basis of preparation and policies are used in preparing the earnout amount and mechanism during negotiations.”
And then there’s the question of how often payments should be made. Consider incorporating milestone-based earnout payments to manage cash flow and ensure continuous alignment.
Escrows vs Earnouts
An earnout, as we discussed, is a payment dependent on future performance. On the other hand, an escrow is a payment dependent on the absence of post-closing claims or issues.
Earnouts are incentivization structures, while Escrows are a mechanism to protect the buyer from unforeseen liabilities or breaches by the seller. With an earnout, the seller has to work for their payout. With an escrow, the seller just has to avoid breaking the law, or handing over damaged goods.
While earnouts share the risk of future performance between the buyer and seller, escrows are protection purely for the buyer against bad stuff.
They also differ in terms of timeframe. Earnouts are typically one to three years, while escrows are often shorter - sometimes weeks, months, or a year (in most cases, a max of two years).
Incentives Drive Outcomes
Most of the people involved in an earnout are not long for this world once the earnout hits. Unless they absolutely LOVE being part of the new co, they will usually chalk it up as time served, and move on to their next entrepreneurial endeavor.
You have to remember that most people with an earnout are start up folks who like building. Therefore, the buyer has to honestly assess how long they will contribute to the new co, and how that shortened timeframe may impact how they go about achieving the earnout’s goals.
In other words:
“Show me the incentive and I'll show you the outcome.”
-Charlie Munger
That being said, because many earnouts include a ratchet or multiplier based on a certain performance metric, it can be in the seller’s best interest to do everything they can to skew it in their direction:
“An earnout is often linked to a multiplier or a ratchet. For example, for every $ in excess of a minimum EBITDA, the earnout could be a multiple of 5x. The earnout can then be easily skewed by a relatively small impact on the profit metric.
By way of a simple example, sellers might receive a multiple of 5x for every $1 that EBITDA is exceeded over a certain amount (say $2m) but nothing if it is less than $2m.
So, if the business achieved EBITDA of $2.3m for the period, the earnout would be $1.5m ($300k x 5).”
Earnouts may encourage short-term behaviors that are sub-optimal for the business’ longer-term performance, like reducing margins to increase volumes or cutting marketing expenditure. The buyer has to keep a close eye on this.
When that final earnout payment hits
That’s it on earnouts. Next week we clap back with a breakdown on working capital pegs. Get ya popcorn ready.
