Earnout

What Is An Earnout?

An earnout is an agreement when someone sells a business, and they will receive the agreed-upon sale price for the company and additional future payments for hitting specific targets. These help when two parties disagree on how much a business might be worth.

For example, suppose a buyer thinks a company is worth $500 million, and the seller thinks the business is worth $600 million. In that case, the difference of $100 million can be structured to bridge the valuation gap. 

The targets can be based on several factors, such as EBITDA and revenue targets. 

Earnouts are common and frequently are involved during a merger or an acquisition deal when the seller is motivated to get the highest sale price possible. The buyer is motivated to negotiate the lowest possible sale price.

Understanding Earnouts

Earnouts, formally called “contingent considerations,” depend on a payout level, which also depends on the business size. They help bridge the gap when the buyer and the seller of a business disagree on a price. 

There are two components: 

• An upfront purchase price 
• Contingent future payments based on performance

This will help the buyer reduce the risk of uncertainty as only part of the cost is paid upfront, with the rest being paid later if the business hits specific financial targets. These targets could be net income revenue or other key performance indicators.

These targets can last one to several years and depend on the business size. Earnouts are not worth as much to pessimistic sellers. Still, they can be valuable to optimistic sellers, as they can earn more from the deal if they outperform their targets. 

When are Earnouts used?

They are used in various scenarios to help. Most are used in M&A transactions when there is a gap in valuations between bidders and sellers. For example, the buyer might be more bullish about the growth prospects of a target company than the seller. 

They help motivate the seller to continue contributing to the business post-sale. However, there is the risk that the total price will be realized if the business fails to meet its targets. 

Here are a few instances in which earnouts would be used:

1. Valuation Gap: As we have discussed, the most common use of contingent consideration is when there is a disagreement on a company’s value valuation. This will lead to an agreement on a compromised upfront purchase price with various incentives for the seller to hit over the coming years.
2. Rising interest rates: If there are economic factors, such as increasing interests, that inhibit a particular transaction, the buyer will be motivated to delay future payments when economic conditions improve.
3. An incentive for proper transition: The buyer may also use the later payments to promote the seller to operate the business most efficiently, hitting financial incentives and achieving valuable growth. This way, the buyer will take control after multiple years of high performance.
4. New company: If the buyer purchases a young business from the seller, it may have a limited history of high performance. Therefore, contingent considerations can be used for companies with short histories but high growth potentials, lowering the buyer's risk.

Structure of an Earnout

The structure is a vital transaction process to ensure proper business transfer. The structure will include how the business is run, who will control it, and other essential elements.

The following are the common components of the structure that are important to consider.

1. Executive Role: One of the primary roles that needs to be agreed upon is the seller’s involvement in the business moving forward and how much control they will have in operating the business.
2. Management team: Members of the management team are essential considerations that will enable the business operator to continue efficiently operating the business with skilled managers who know the industry and how to manage it, maximizing the probability of reaching targets.
3. Duration of agreement: The business's seller may favor negotiating a short-term contract duration to prevent possible failure or disagreement with the buyer. Thus, it may benefit the seller to have a short-term deal. Nonetheless, the length of the agreement is a significant portion of the structure.
4. Control: The seller and buyer must also agree on the business structure of the plan moving forward. Critical expectations of the post-acquisition roles and business functions are essential. 
5. Key performance indicators: The metrics used to define the business’s success are essential to ensure no confusion about the necessary measures. Sellers prefer revenue as the contingent considerations’ key metric as it is difficult to manipulate.
   Common measures include:

    

   • Revenue
   • EBITDA
   • Net income 
   • Earnings per share (EPS)
6. Accounting Principals: Besides deciding on the key performance indicator, agreeing on the agreement's rules is also essential to ensure mutual accounting about the financial target underlying the earnings. 

Conflicts in earnouts

Buyers and sellers argue about buying/selling the business for different prices at the end of the day. The buyer will do whatever possible to present the company in a light that leads to a lower sale price. 

If there is a disagreement, the buyer will present financial statements that outline the overall performance of the company and the metric on which the contingent consideration is determined, to which the seller will have the opportunity to review and offer a rebuttal. 

Typically, there will be an arbitration clause in any signed definitive agreement between the buyer and the seller.

Implications in markets

This article from the WSJ does an excellent job explaining the state of M&A in 2023 and how contingent considerations are used to close deals in the market in various conditions. 

This is because deal activity has slowed, and sellers have less bargaining power, making it difficult to refuse a contingent consideration deal.

Companies often need help to agree on prices to facilitate these transactions during inflationary market conditions and rising interest rates. When this happens, financing becomes more expensive, and company valuations decrease. 

But, increasing stock prices will cause sellers to demand high prices, creating a gap between buyers and sellers. Contingent considerations are then used to break the deadlock in a negotiation.

Types of earnouts

There are numerous types. For example:

1. Financial earnouts: These can be based on specific financial metrics. These are the most common types based on revenue, EBITDA, net income, or other financial metrics. They are used when financial performance is expected to improve.
2. Operational earnouts: These are based on operational metrics such as customer metrics, product developments, or product milestones. These are used when the transaction is expected to improve operations and achieve the desired strategic objectives. 
3. Hybrid earnouts: These use a combination of financial and operational objectives and are most commonly used when a target has financial and operational objectives that are desired to be met. 
4. Time-based earnouts: These are based on time instead of performance. These are common when the target has long-term growth prospects and may contain a milestone needed, such as new product development, within a certain timeframe.
5. Reverse earnouts: These benefit the seller if the buyer fails to achieve an objective. These are common when the buyer is acquiring a business that is considered risky, typically when the buyer is needed to help the seller develop a certain product.

Typically, contingent considerations are paid in variable amounts, and the seller will get to keep a quantity fractional of profits above a certain threshold. For example, for anything above $50 million in net income, the seller may get to keep 50%. 

So, if net income were $60 million, the seller would get to keep an extra $5 million.

How common are earnouts?

According to this Harvard Law School forum, 37% of mergers and acquisitions in 2023 contained an earnout provision. This is down from 43% in 2022 and up from the usual 20-30% from pre-pandemic levels.

They are much more common when a private company is acquired than a public one. This is because public companies must file annual financial statements and disclose information, and private companies have less available information in the marketplace. 

Since a private company does not have to publish such information, it will be harder for a buyer to gather the necessary information to make an informed valuation, making it easier for the seller to oversell itself. 

Private companies can withhold information and create an information asymmetry during due diligence. This is where contingent considerations can be advantageous, offering a vehicle to bridge the gap of any discrepancies due to this informational barrier.

The prevalence is also dependent on the industry in which the company operates. There are more contingent considerations in sectors with unpredictable business cycles, such as technology and healthcare.

Example of an Earnout

Let’s understand earnout by taking a simple example. Suppose SellCo’s annual sales are $100 million, and net income is $20 million. 

BuyCo wants to buy SellCo for $500 million. However, SellCo's owner believes It is worth $750 million and counters with this amount.

BuyCo and SellCo agree to engage in a contingent consideration to bridge the gap. BuyCo will give SellCo $500 million now and another $250 million if SellCo can maintain sales of $125 million over the next four years. 

However, BuyCo will only give SellCo an extra $110 million if SellCo fails to meet this target.

Recent Earnouts

Some recent earnouts are:

• Zillow Group acquired Follow Up Boss, agreeing to pay $400 million in cash up-front, plus another $100 million over three years if Follow Up Boss met a set, undisclosed objective.
• Insight Enterprises acquired SADA for $410 million and an additional $210 million over a specific time frame if conditions are met. 
• Spin Master acquired Melissa & Doug for $950 million with a $150 million contingent consideration over two years based on operations.

Earnout Advantages and Disadvantages

The buyer and the seller will also experience advantages and disadvantages. 

The advantages are:

1. The buyer experiences an advantage in a safer transaction. By deferring part of the payment over time, the buyer will have more cash in the present to deploy how they see fit. It also reduces the risk of a discrepancy in valuations. 
2. Essential managers are also kept to help run the business and motivate them to run it efficiently to hit targets. 
3. The purchase price will decrease if the earnings targets are met. 
4. The seller has extra future payments in the coming years.

Some of the disadvantages are:

1. The buyer also has disadvantages because the seller has been involved in the business for a more extended period, possibly causing disagreements about operations.
2. The seller has disadvantages in the increased risk of losing money received for the business. Suppose financial targets still need to be met in the future. In that case, the seller will miss out on an additional purchase price initially deferred by the buyer.
3. Contingent considerations can also involve a lot of legal caution tape. There may be controversy over how the buyer will support the seller during the period leading up to the earnout, as well as if the buyer and seller disagree on whether the conditions were met and whether the earnout should be paid.

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

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