Earn-Outs in M&A: A Comprehensive Guide for Entrepreneurs

Almost all PEGs offer selling managers the opportunity to buy equity in their target company for the same price the PEG paid (“roll-over” equity). We hope that you’ve found this article valuable when it comes to learning what an earnout is in the M&A process – thanks for reading! Earnouts are a powerful and popular tool in M&A transactions that help bridge valuation gaps and move deals forward. However, these deals can take several different forms. Let’s explore a quick example of how an earnout works…

Structuring Earnouts in M&A: Key Strategies, Metrics, and Negotiation Tips

• Staggered payments are one potential alternative to earnouts.
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• The buyer mitigates risk by deferring part of the payment, while the seller has the opportunity to receive a higher payout if the business performs well post-acquisition.
• However, the real underlying issue is that the buyer doesn’t think the company is worth $75 million and doesn’t believe they can scale to $100 million in the next 5 to 10 years.

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So, they hire fewer members of the seller’s team and for less time. On the other hand, strategic buyers are operators themselves and they therefore often believe they’re already well-supplied with management talent and admin support. (See The Cause of Most Bad Deals for more reasons why deals go bad.)

Accountability through Operational Covenants and Diligence Standards

While at SRS Acquiom, Casey has represented shareholders’ interests on hundreds of deals, including defending claims up to $400 million and administering life sciences deals with as much as $1 billion in contingent consideration. Earnouts should be negotiated and drafted with an eye toward clarity, pragmatism and avoiding post-closing disputes. The type and size of the target business plays an important role in deciding what factors should be addressed. This article provides high-level information on what you need to know about M&A earnout provisions to make informed decisions and maximize the opportunity for a successful M&A transaction.

The measurement period and ongoing obligations typically extend into the post closing phase, requiring both parties to remain engaged and aligned after the transaction is finalised. Sellers often retain rights to access financial information, participate in business planning discussions, and receive regular performance updates. Buyers must balance their desire to integrate the acquired company with the need to maintain accurate earnout measurements. Without precise documentation, even straightforward earnouts can become sources of significant conflict. In the event of disagreements over the calculation of the earnout amount, an independent accountant may be appointed to review the financials and make a binding determination. The SPA must specify how performance will be measured, who will prepare the relevant calculations, what accounting standards apply, and how disputes over earnout achievements will be resolved.

Understanding Earnouts In M&A Through An Example:

Sellers must ensure that the business is adequately capitalized and has the necessary resources to hit agreed-upon targets. A common pitfall is setting unrealistic or ambiguous performance targets that are either unachievable or subject to differing interpretations, leading to disputes. This harmony keeps the company on a path to success and ensures that both the buyer’s investment and the seller’s legacy thrive. It’s all about crafting an agreement where the seller’s actions, driven by the desire to meet earn-out criteria, dovetail beautifully with the strategic goals and vision of the business.

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Additional $5M if company reaches $20M revenue in Year 2 Performance-based payments over 2-3 years Initial cash consideration at closing These might include revenue milestones, profitability, customer retention, or other specific business objectives. Parties must also navigate marketplace changes, ensure fair transaction value, and consider the impact of goodwill on the deal’s overall valuation. Metrics such as pipeline development, market inclusion, and the discount rate are vital for accurate performance tracking and valuation.

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• Company A is open to selling and Company B believes this transaction will add significant value to their business over the next ten years.
• Even if equity constitutes only a portion of the earnout, it can reduce the likelihood of conflict, serving as a cushion to the seller if other benchmarks are missed.
• How do you account for an earnout writedown?
• Let us say the target that needs to be achieved is 30% revenue growth year-over-year for the next two years.
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• Earnouts often lead to disputes over whether the business was improperly managed by the buyer, or whether the buyer intentionally prevented the earnout from being maximized.
• But again, in any specific company, what does that really mean?

This structure ties a portion of the purchase price to the future performance of the acquired business, which is particularly common in industries such as medical device transactions. They often arise from differing interpretations of the earn-out terms, claims of business manipulation to deter payouts, or disagreements on the calculation of target achievements. Moreover, the earn-out should be contingent upon the overall results of the business, not personal performance, and individuals should be compensated at market rates, including any bonus arrangements. A well-drafted earn-out agreement can be the smooth tarmac for a successful post-merger integration, so invest the time and expertise to get it right. Incorporate robust legal language, conduct thorough diligence, and engage in open and honest dialogue to construct an earn-out that’s a win-win for both buyer and seller.

Earnout Design Considerations

In addition, to provide a framework for interpretation and minimize potential ambiguities, parties may consider including general statements of intent regarding the earn-out or illustrative examples within the agreement. After considering the surrounding circumstances, the court accepted the seller-plaintiff’s view that “company products” included software developed after the merger that made use of the seller’s purchased source code and entered a multimillion-dollar judgment in favor of the seller. This data provides a snapshot, though we note that the first quarter of 2023 had an exceptionally high number of dockets mentioning “earn-out” and “M&A.” It also is important to note that many earn-out disputes are resolved privately, suggesting that disputes regarding earn-outs are more prevalent than the case dockets suggest. Sellers generally favor revenue-based targets, which are top-line, and less vulnerable to manipulation through changes in cost structure or accounting treatment. Most earn-outs are structured with financially-based metrics, with revenue as the most popular metric, followed by earnings or EBITDA.

Breaking Down the Earn-Out Payment Structure

Some agreements allow for catch-up provisions if targets are missed one year but exceeded the next. The amount can be a flat sum per period, a formula based on how much the target surpasses a threshold, or a percentage of performance. Earn-out payments can be structured as a single payout at the end of the earn-out period or multiple payments at regular intervals. Financial targets are common but tend to be more susceptible to accounting interpretations and manipulation.

Many of the advantages from the buyer’s point of view are not advantageous to the seller of the business. The seller will have a different perspective concerning the earnout agreement. An earnout means they pay less up front and therefore have to borrow less money at the higher interest rates. This is often a strategy that buyers employ in times when interest rates are higher than normal.

This structure is particularly helpful if the seller believes strongly in the company’s trajectory and wants to participate in the upside. With an earn-out, the seller secures immediate base consideration plus the potential for more if growth projections come true. By structuring part of the price as contingent on future success, the deal can move forward while leaving the ultimate valuation partly dependent on outcomes that will unfold after the transaction closes. Understanding earn-outs, their advantages and disadvantages, and how to structure them effectively is essential if you want to achieve a favorable outcome when selling your business or acquiring another entity. As an entrepreneur considering a merger or acquisition, one key issue you may encounter is bridging the valuation gap between your company’s perceived worth and what a prospective buyer is willing to pay.

Additionally, as an older, long-established business they see this M&A transaction as a way to eliminate a high-growth competitor that is partially disrupting the space with a unique offer. They see that a potential deal would give them access to a new market and give Company B the opportunity to upsell Company A’s existing customers Company B’s higher-priced consulting services. This needs to be clearly defined and agreed upon by both parties. Fourth, we have the accounting assumptions that will be used to measure performance. Earnouts can be structured so that the amount paid is a lump sum (ie. $10 million), a percentage of revenue (ie. 5 percent of gross sales), or a percentage of earnings (ie. 10 percent of EBITDA).