Mergers and Acquisitions (M&A) are complex business deals that involve significant risks, particularly when it comes to valuing the acquired company. To mitigate these risks, an earnout structure is often used in M&A transactions. An earnout is a contractual arrangement that links the purchase price of a company to its future performance. There are pros and cons of using an earnout in a M&A transaction.
Flexibility in Valuation: Earnouts offer flexibility in valuation, particularly in cases where the buyer and seller have different views on the company’s value. The earnout structure can help bridge the gap between the two parties by tying the purchase price to the company’s future performance.
Incentivizes Seller: Earnouts provide an incentive for the seller to work with the buyer to achieve the agreed-upon goals. This collaboration can help ensure that the business’s operations continue smoothly post-acquisition, as the seller has a vested interest in its success.
Risk Mitigation: Earnouts can be used to mitigate risks associated with uncertainties in the business’s future performance, such as cyclical trends in the market or regulatory changes. An earnout can provide some protection to the buyer by ensuring that the seller bears some of the risks associated with future performance.
Reduced Upfront Payment: Using an earnout structure can enable the buyer to pay a reduced upfront payment, which can help conserve cash flow and reduce financial risk.
Disputes and Litigation: Disagreements about how to measure the business’s performance and which milestones should trigger additional payments can lead to disputes and even litigation. This can be expensive, time-consuming, and distract from the post-acquisition integration process.
Lack of Control: The buyer may have limited control over the business’s performance during the earnout period, which can create uncertainty and make it challenging to plan for the future.
Complexity: Earnouts are complex to structure and administer, which can increase the transaction’s overall complexity and cost.
Difficulty in Execution: It can be challenging to develop meaningful and objective criteria to measure the business’s performance, particularly if it is a start-up or has a novel business model. This can make the earnout difficult to execute in practice.
So, the cons sound bad. Why would you consider it? When structuring an earn out, it is key to make sure you are thoughtful in the parameters that you put into place. Since you don’t own the company while an earn out is being achieved you need to make sure that you get the comfort around the calculations. This is where your deal team is critical. Your accountant will be the first line of review for the earn out calculations – so work with your advisor and your accountant to make sure the M&A attorney drafts the language in the terms that work for the deal. For example, a percentage of revenue is better than a percentage of profit. But the length of time that you collect and earn out as well as how often they are paid are all considerations. Use your deal team to make sure you are in the position to collect your earn out!
To summarize, earnouts can be a useful tool to bridge valuation gaps, incentivize sellers, and mitigate risks in M&A transactions. However, they also come with downsides, including increased complexity, potential disputes, and a lack of control. As such, buyers and sellers must carefully evaluate the pros and cons of using an earnout and ensure that they have clear and objective criteria for measuring the business’s performance. Ultimately, the success of an earnout will depend on the parties’ ability to work together collaboratively and to ensure that the earnout is structured appropriately for the particular transaction.