Earnouts are sometimes used in M&A transactions to bridge the valuation gap between buyers and sellers. With the continued uncertainty resulting from the COVID-19 pandemic and the corresponding supply-chain disruptions, product shortages, and rising costs of goods, the valuation gap in M&A transactions is even greater. As a result, buyers and sellers are increasingly using earnouts to help them close transactions.
While an earnout may sound like a reasonable solution that ties a portion of the purchase price to post-closing metrics, buyers and sellers can find themselves in disputes if the terms are not well-defined. For example, an earnout can be based on financial metrics or non-financial metrics. It could be an all-or-nothing payout or a pro-rata portion of some maximum amount. It is important for buyers and sellers to carefully consider all options when working to align strategies that can have many variables.
Why Are We Seeing More Earnouts?
The challenges confronting businesses today are a direct result of the unrelenting chaos caused by the global pandemic. Manufacturers worldwide are limiting production, despite demand for their products reaching all-time highs. Shortages in raw materials are not only the result of shutdowns, but supply chain disruptions and worker shortages have created delays at shipping ports, distributors, and businesses supplying those goods and services.
With the uncertainty regarding the timing of a return to normal, buyers and sellers hope to close the valuation gap through a measurable solution – an earnout.
What Is an Earnout?
An earnout is a contractual arrangement between a buyer and seller in which a portion of the purchase price is deferred and is later paid to the seller based on the acquired firm achieving predefined financial or non-financial metrics.
An earnout is a particularly useful tool when there is a disagreement in value between the buyer and the seller, which often is driven by differing views on future expectations or the likelihood that a specific event will occur in the future. The ongoing pandemic continues to challenge buyers and sellers alike with predicting their industry’s near-term future. Will the vaccines help reduce the spread of the virus and many of the variants spreading globally? Will vaccine immunity wane over time and will booster shots be on an annual basis. Will new vaccines need to be developed due to fast-spreading variants? Will the pandemic end within the next year, or will it drag into 2023 or even longer? No one really knows. Hence the greater uncertainty for many businesses and the great challenge to forecast future financial results with any accuracy.
Sellers would contend that the crisis will come to an end soon and that basing valuations on current market conditions alone is too narrowly focused. On the other hand, buyers want to mitigate risk and protect themselves in the event the target company does not rebound to pre-COVID levels.
Other Reasons for Including an Earnout
While differing views on value and forecasting are the most likely reasons for an earnout, there are other benefits. When an earnout is paid out over time, buyers defer paying a portion of the purchase price and can use earnings generated from the acquired business to help pay the earnout.
Buyers also benefit from the likelihood that sellers will work to ensure a smooth transition and are less likely to compete. Through a deferred payout arrangement, sellers maintain “skin in the game.”
Benefits do not all go to the buyer. Sellers benefit as they can actually realize, albeit later, the full purchase price of their business from a buyer who today might be doubting the value. A deferred payment stream can enable the seller to defer or even reduce taxes.
Metrics and Structure of an Earnout
Earnouts can be complex to design, and with the market turmoil created by COVID-19, buyers and sellers should be even more diligent when structuring an earnout. Earnouts can be based on non-financial metrics, such as achieving new contracts or adding new stores.
More often, earnouts are based on financial metrics such as revenue or EBITDA targets. Such metrics should be well-defined and include details of the accounting standards used, how general and administrative expenses, including corporate overhead will be handled, or what adjustments will be incorporated when determining the metric.
Just as important as defining the financial metric itself is the structure of an earnout. The payout terms should be clearly identified and should consider all options that align the strategies of buyers and sellers. Many earnouts are binary in that they consist of an all-or-nothing payout. Sellers would benefit from a payment that is prorated, especially during a COVID-19 economy, where the payoff amount is based on achieving a percentage of the overall metric.
Similarly, a catch-up provision would be beneficial for the seller where the acquired entity might miss forecasted results in the short term but rebound in later years. Under this arrangement, it is important to have an earnout structure that is measured over several years.
Consider the Litigation Risk
While an earnout might sound like the right approach to help bridge the gap in valuations between buyers and sellers, litigation can be all too common if very specific and detailed terms are not clearly stated in the earnout agreement.
Buyers and sellers might want to consider a separate agreement that details procedures for disputes arising from arguments over an earnout. Including examples of how a metric should be calculated or identifying who would be best suited to corroborate financial metrics might reduce litigation risk. Being as clear as possible is key to avoiding court battles and the associated costs.
Expectations are difficult to predict in normal times, and with COVID-19, expectations are harder than ever to pin down. Buyers and sellers are finding themselves forced to work through disagreements about valuation and, ultimately, the purchase price. When carefully and thoughtfully constructed, earnouts can be an ideal solution to align longer-term interests when the economic and company futures are cloudy.