By: Neal England
Earnouts are widely used mechanisms by strategic and financial buyers during an M&A transaction that enable a buyer and seller to bridge gaps in valuation and help a buyer mitigate risk. Under an earnout, a portion of purchase price is deferred, and receipt is contingent upon the acquired business achieving certain growth-related benchmarks post-closing. Essentially, a seller agrees to stay on for a period of 1-2 years (or longer) after closing to help drive growth and integration initiatives towards revenue, gross profit, or EBITDA benchmarks as mutually agreed between the parties. When the benchmarks are achieved, the deferred portion of purchase consideration is paid. An earnout can be a terrific mechanism to gain additional purchase consideration if benchmarks are exceeded. However, if benchmarks are missed then a seller can expect to receive reduced purchase consideration or even lose the entire deferred purchase consideration subject to the level of shortfall. Earnouts can be a calculated risk and a big win for a seller who has a solid handle on their business and enough energy and determination to drive growth for a short-term period toward a goal. A good acquiring partner (financial or strategic) wants to see the seller hit their goals and pay the earnout because they know the result means greater profitability and growth from the enterprise they acquired. This mindset from a quality buyer greatly reduces any sense of conflict from a seller. Negotiating favorable earnout terms is a complex process and it is important for sellers to understand the following key factors to focus on during negotiations:
Achieving and exceeding post deal benchmarks is critical for buyers to receive their earnout proceeds. These benchmarks are typically based on projections shared with buyers early in a process to demonstrate the seller has a vision of future growth potential. Projections need to be properly crafted to provide buyers with enough insight that excites them about growth potential without creating too high a milestone hurdle to clear. Markets change, key people leave, and large clients can be lost during an earnout period so be sure to factor these possibilities into projections.
Earnout measurement metrics are typically based on revenue, gross profit, or EBITDA. Revenue and gross profit-based milestones are more controllable for sellers especially when buyers plan to achieve some level of integration. Finance, IT, payroll, legal, and HR can normally be integrated at some level into a buyer’s operation without interfering with sales and service revenue growth. Sometimes a seller’s gross profit can gain a boost by assuming some of the buyer’s COGS expenses, because these expenses are likely at a lower price point due to the buyer’s broader buying power. Frequently, however, earnout measurements are based on EBITDA in order to be consistent with the initial valuation metric. While the buyer effectively is the new owner, a seller can negotiate certain provisions in the purchase agreement preventing the buyer from inserting management fees into the P&L, manipulating expenses, or redirecting/distracting key performers without a seller’s consent. Quality buyers usually agree to inserting language in the purchase agreement stating they will operate in good faith and deal fairly to provide sellers a fair opportunity to achieve the earnout. Maximizing operating autonomy and reducing buyer interference post-closing during the earnout is extremely important for hitting goals.
Cliff and ratchet mechanisms are two commonly used methods to determine how much of the earnout will be paid, if any. Both are based on the actual performance achieved compared to the projected benchmark. A cliff mechanism is an “all or nothing” provision where an earnout is paid when the target is hit and isn’t paid if the target is missed. This can be harsh treatment if you are close to a target yet still miss the milestone. A ratchet mechanism is a more common approach and means the actual earnout paid
will ratchet up or down by a pro rata percentage based on the actual performance. Ratchets are more reasonable because if you deliver less target then you receive less earnout, and if you deliver more target, may you receive additional earnout. Purchase structure and buyer’s agreement to the earnout will determine important nuances how a ratchet will perform for both parties in any given transaction.
Converting from entrepreneur to employee is hard for sellers who created an enterprise that is undergoing a change in control under an acquisition. Entrepreneurs don’t usually make good employees and buyers realize this. If you are the type of selling entrepreneur who must have things your way or always maintain the final word after a closing, then you should consider avoiding an earnout structure. On the other hand, if you can tolerate and adapt for a short term in exchange for the upside potential purchase consideration then this structure might beneficial. At the end of the day, great buyers understand it’s not easy for entrepreneur sellers to adapt to this kind of change and they normally strive to make the transaction a partnership where both parties work together to execute towards a new common vision. In these successful partnerships, sellers can avoid the conflicted nature of earnouts and often hit their targets for the benefit of both parties, gain board seats, or advance under executive or advisor promotions if they choose to continue after the earnout period.
Other points to consider:
- Early earnout payout if targets are achieved early
- Make up or catch-up provisions
- Differences between GAAP and seller accounting practices
- For smaller buyers, escrowing of minimum earnout potential
As with all transactions and negotiations, the devil is in the details and ensuring that you, as the seller, have a strong M&A advisor and legal counsel will help ensure that any earnout is structured fairly with market driven terms. At Founders, we always work to ensure as much of the transactional consideration as possible is guaranteed, and any earnout is viewed as “icing on the cake.” If a transaction is on the horizon for you and your company, we would welcome the opportunity to share additional insights around our process and when earnouts could be a useful transaction mechanism to maximize purchase price.