Earnout
It is a method used in mergers and acquisitions (M&A) in which the seller is guaranteed future payments in addition to an initial payment upon reaching particular milestones
What Is an Earnout?
Earnout is a legal provision in a merger or acquisition agreement that outlines potential future payments from a company's buyer to the seller's shareholders.
They are often considered to have been "earned" when the acquired company achieves specific financial or other benchmarks after the purchase is finalized.
If the parties have trouble agreeing on an upfront cash price, they may help reconcile the buyer and seller's divergent value viewpoints. They are typically included in acquisitions of privately held businesses, while they can occasionally be included in acquisitions of publicly traded businesses.
This may frequently result in disagreements between the buyer and the seller over whether it was legitimately obtained or whether the buyer unfairly prohibited it from being maximized. Such a clause in a contract states that the seller of a firm will receive future remuneration if the company meets specific financial targets.
A seller's earnout is typically used to reconcile a buyer's divergent business expectations. Because the buyer only pays a fraction of the sale price upfront and the remaining amount depends on future performance, this removes uncertainty for the buyer. As a result, future growth benefits are transferred to the seller.
Such recipients, accounting assumptions, and a specified time frame are important contractual factors. It is based on future financial success, so it helps the buyer remove uncertainty. The buyer pays a portion of the purchase price upfront, and the remaining amount is contingent on achieving future performance goals. For a while, the seller also benefits from potential future development. It may be based on financial goals, such as net income or revenue.
Key Takeaways
- An earnout, also known as contingent compensation, is a term in an M&A deal in which a buyer promises to make future payments to the seller dependent on the performance of the target firm, therefore bridging value differences.
- Earnouts benefit purchasers by decreasing the risk of overpaying and providing flexibility in operating the purchased firm, but they may lead to disagreements with sellers over payment conditions and management.
- Defining financial indicators, deciding the period of the agreement, considering executive positions, accounting standards, and selecting whether payments are delivered all at once or in installments are all important components of creating an earnout.
Understanding an Earnout
In a nutshell, an earnout, also known as contingent consideration, is a method used in mergers and acquisitions (M&A) in which the seller is guaranteed future payments in addition to an initial payment upon reaching particular milestones.
Its goal is to close the valuation gap between the overall consideration a target is seeking and the price a buyer is prepared to provide.
Buyer’s Perspective
- They are seen as having several advantages by buyers. First, rather than relying exclusively on the seller's anticipated performance, the acquisition's total price can be determined by considering the seller's future performance.
- By doing this, the danger of overpaying for a company can be reduced for the buyer.
- The key management team of the seller, who will continue to run the company successfully after the acquisition has been completed, may benefit from an earnout as a retention and incentive tool.
- As the business climate evolves, the buyer will frequently desire the most flexibility possible regarding how it may run the purchased company after the closure.
- The buyer doesn't want to be constrained by excessively severe limitations, covenants, or seller-protective clauses. There is a clear conflict between the buyer and the seller.
Seller’s Perspective
The seller typically wishes to get most of the purchase price in cash when the sale closes.
However, a seller that is willing to accept would be concerned about the following issues:
- First, are the milestone targets for it to be feasible and attainable quickly?
- What safeguards can the seller put in place to ensure that the purchaser doesn't run the company in a way that reduces or eliminates such payments?
- What guarantees will the buyer provide to sustain the company and increase the possibility that the maximum amount will be realized?
- Does the anticipated payment size warrant a delay in the seller receiving all cash up front?
- Is there a way for the seller to prevent the purchaser from damaging such payments by tampering with the business's financial metrics?
Structuring an Earnout
In addition to the cash payout, there are other important factors to consider when arranging an earnout. This entails identifying the key players in the organization and deciding whether to provide them with it.
Two more aspects that need to be agreed upon are the contract's duration and the executive's position inside the business following the acquisition. Again, this is the case since management and other important personnel directly impact the company's performance. If these employees quit, the business might not reach its financial goals.
The agreement should also state the future accounting assumptions to be applied. Management decisions can still impact the results, even if a corporation follows generally accepted accounting policies (GAAP). The assumption of a higher level of returns and allowances, for instance, will result in lesser earnings. Current earnings may be negatively impacted by a change in strategy, such as the choice to close a company or invest in growth projects. The seller needs to be informed of this to find a fair resolution.
Also, it is necessary to choose the financial criteria that will be utilized to calculate the amount. While certain indicators help the seller, others assist the buyer. Therefore, using a variety of indicators, such as sales and profit measurements, is a smart idea.
Financial and legal consultants are available to help during the entire procedure. Generally speaking, the intricacy of the transaction increases the consultants' charge.
1. Useful financial metrics
A milestone based on the company's gross revenue is more susceptible to manipulation by the buyer. Occasionally, sellers use gross profit (net sales less cost of goods sold) as a compromise benchmark.
2. Involvement non-financial metrics
Payments for reaching milestones may also be based on accomplishing non-monetary objectives. In biopharma purchases, for instance, these are frequently incorporated, with goals linked to the completion of clinical studies or FDA approval.
3. Period
Before this is received, how long must the financial goals be met? Is it for the current fiscal year? Determining a reasonable approximate time frame for reaching corporate goals and milestones serves as a qualitative motivation for a company to expand..
4. All at once or in installments?
Before receiving any payment, is there an absolute threshold that must be reached (for example, $200 million in gross revenues in 2022), or is it graduated (for instance, $160 million to $240 million in gross revenues in 2022)?
With graduated earnout payments based on actual gross revenues attained between $160 million and $240 million)?
5. Minimum and maximum payments
Many earnouts set a maximum payout, while some impose a minimum payment requirement in the future. The seller will want the buyer to place any future minimum payments into an escrow to guarantee they are made so that they can be paid, if necessary.
6. Application of Accounting Standard
- What will accounting rule be used to assess if the financial metrics have been met?
- Before the acquisition's conclusion, what were the seller's accounting standards?
- GAAP routinely used?
- Accounting guidelines of the purchaser?
- What procedures will be followed to handle synergies, intercompany fees, and allocations?
Advantages of an Earnout
It can be advantageous to a company's buyer and seller. These can fill the gap between what each party believes to be a reasonable purchase price and assure the purchaser that the seller would endeavor to make the deal fruitful after the sale.
Be mindful when using them and extremely diligent when choosing and structuring them.
Benefits for buyers:
1. Less uncertainty for the buyer: The final sum they pay depends on the company's performance, so the buyer is less hesitant about their investment. They invest less money overall in the business if it is not as profitable as they had hoped.
2. Greater payment flexibility: Buyers are given more time to pay for the company's acquisition, which is frequently more convenient for them financially.
3. Smaller first payment: Compared to purchasing a company at its full market value, the initial purchase price is frequently more affordable for the buyer.
Benefits for sellers, such as:
1. Continued income: The seller has a continuing source of income provided such payments they receive over time.
2. Reduced tax payments: Since the sale of the company is spread out over several years, the seller's tax liability is also dispersed over a longer period.
3. The buyer is incentivized to maintain the company's reputation and performance since they stand to gain from its success.
4. It must be correctly and fairly structured to benefit both parties.
Disadvantages of an Earnout
Depending on the company's performance and the contract's specifics, they have a few drawbacks. An earnout resembles a bet on the company's future accomplishments.
Although you may have faith in your business, your team, and your customer understand that you will have little to no influence once the deal is closed.
Consider thoroughly how much of the purchase price you want to be conditioned on the business's success under the new buyer. Likely, none of the earnouts you anticipated will ever materialize.
The following are possible drawbacks for buyers:
1. The seller is still connected to the business. The seller may attempt to assist or counsel the buyer because they still have a financial stake in the company. Because of this, many such contracts include that the seller is prohibited from participating in the firm after a specified time.
2. Low profits: If a company's profits are too low, a buyer may not be able to pay it back as quickly. Many such agreements contain clauses to safeguard the buyer from insolvency in this situation.
The following are possible drawbacks for sellers:
1. Persistent involvement with the business: The seller may feel obliged to follow the business's progress and participate since they still have a financial stake. This can be time-consuming and taxing.
2. Less profit: The seller makes less money from the sale of the company if profits or sales do not meet a specified threshold.
3. Such contracts must contain information on every term and condition. They are very complicated. If improperly written, they may cause misconceptions and be perplexing to both the buyer and the seller.
Valuation Challenges in Sanofi-Genzyme Deal
These can assist parties in coming to a consensus on valuation-related concerns, as demonstrated by Sanofi's 2011 acquisition of Genzyme. Sanofi announced that Genzyme would be purchased on February 16, 2011.
During discussions, Genzyme's assurances didn't persuade Sanofi that earlier production challenges with some of its products had been entirely overcome or that a new drug in the works would be as effective as claimed.
This valuation gap was closed by both parties in the following ways:
- At closing, Sanofi would pay $74 per share in cash for each share in the company.
- Sanofi would also pay an extra $14 per share, but only if Genzyme met specific financial and regulatory targets.
All the precise requirements to meet the earnout were identified and listed in the press release for the Genzyme deal.
- When the FDA grants Alemtuzumab approval by March 31 or earlier, a $1 milestone will be reached.
- If 734,600 units of Cerezyme and 79,000 units of Fabrazyme were manufactured by December 31, 2011, the production would have reached the $1 milestone.
- Four specified Alemtuzumab sales goals must be met before Genzyme will pay out the remaining $12. (Each of the four goes into further detail in the press release).
As a result of failing to meet the milestones, Genzyme sued Sanofi, alleging that as the company's owner, Sanofi could not do its share to make the goals feasible.
Earnouts in an M&A transaction
These can be helpful tools in mergers and acquisitions to assist in closing the valuation gap between a buyer and a seller during the negotiation stage of a deal.
Many M&A consultants are turning to it to aid in closing deals as supply chain problems, workforce shortages, and rising costs continue to impact the present market.
They can save a deal, but if not specified in the purchase agreement, they can cause dissatisfaction for both the buyer and the seller.
It involves a buyer making an initial purchase payment for a target business, with potential further payments made over time dependent on the attainment of particular performance measures outlined in the purchase agreement. These performance measures, which are frequently focused on sales or profits, can also be operational or financial.
Earnout FAQs
The parties should have a clear dispute resolution procedure because such provisions frequently result in disagreements. Confidential binding arbitration is a favored method of resolving disputes to prevent protracted and expensive litigation.
This contract clause states that a firm's seller will receive future remuneration if the company meets specific financial targets. A seller's earnout is typically used to reconcile a buyer's and a buyer's divergent business expectations.
Because the buyer only pays a fraction of the sale price upfront and the remaining amount depends on future performance, it removes uncertainty for the buyer. As a result, future growth benefits are transferred to the seller.
An earnout benefits buyers in several ways. First, it reduces uncertainty by tying a portion of the purchase price to the company's post-acquisition performance, making the investment less risky. Second, it provides greater payment flexibility, allowing buyers more time to pay for the acquisition, which can be financially convenient. Lastly, the earnout structure typically involves a smaller initial payment, making it a more affordable option compared to paying the full market value upfront.
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