Earnouts in M&A

Earnouts in M&A

An agreement between a man and woman for an earnout in an M&A deal.

Key takeaways About Earnouts In M&A:

This guide explains what earnouts are in mergers and acquisitions. Additionally, we explain earnouts through an example and explain the rationale behind an earnout arrangement from both the buyer’s and seller’s perspectives. Here are some key takeaways about earnouts in M&A:

  • Earnouts are contractual provisions regarding the terms of how the purchase price of a business will be paid to the seller in a merger or acquisition deal. Earnouts concern how the seller actually gets paid for the business they are selling to the buyer.
  • In an earnout, the buyer doesn’t pay the seller the full amount of the purchase price upfront, they contractually tie a portion of it to future growth targets for the company being sold.
  • Earnouts are often arranged when the seller anticipates receiving a higher payment for their business than what prospective buyers are capable of offering. They are also commonly utilized in economic climates with high interest rates or when buyers have limited access to capital.
  • Earnouts can be structured so that the additional payment will be paid out as either a lump sum, a percentage of revenue or a percentage of earnings—provided the conditions of the earnout are met.

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How Earnouts Are Structured:

An earnout is a contractual provision regarding how the buyer will pay the seller for the business they are buying. In an earnout, the buyer doesn’t pay the seller the full purchase price amount up front, instead they tie a portion of the purchase price to business targets.

Earnouts are primarily used in instances where a privately held company is being purchased. Rarely are earnouts structured for publicly traded companies.

To understand earnouts, you need to understand the contractual considerations made with the arrangement. Here is a list of key considerations in an earnout agreement:

  1. The earnout recipients.
  2. The amount they are paid.
  3. What the agreement is contingent upon.
  4. The accounting assumptions used to determine performance.
  5. The time period in effect.

First, the earnout recipients are the ones that get paid if the conditions of the earnout are met. These are the owners of the business that is being sold. Earnouts can also include considerations for other key executives if structured that way.

Second, we have the amount they are paid. 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).

Third, we have what the earnout agreement is contingent upon. In other words, what needs to happen for the seller to get the earnout amount. Earnouts can be contingent upon revenue targets (ie. the business hitting $100m in revenue), on EBITDA margins (ie. The business maintaining profitability), or around the retention of key executives working in the business. When the earnout is made contingent upon something, that condition needs to be met in order for the earnout recipients to be paid. If the conditions are not met, the earnout will not be paid out to the seller.

Fourth, we have the accounting assumptions that will be used to measure performance. There need to be agreed-upon standards for measuring the financial performance of the business. Accounting standards leave room for interpretation. The earnout should be structured in a way that gives as much clarity to the way financial performance will be determined as possible.

Fifth, the time period in effect must be defined. If the earnout is contingent upon the business hitting $100m in revenue, what timeframe does the business need to hit that revenue target for the earnout conditions to be met. This needs to be clearly defined and agreed upon by both parties.

Understanding Earnouts In M&A Through An Example:

This section is designed to give you an understanding of how an earnout works in an M&A transaction through an example.

As our example, say Company A, a consulting business, has revenue of $25 million and earnings of $7.5 million. They have grown quickly, going from launch to $25 million in revenue in just under five years. After achieving strong product-market fit, dialing in an extremely effective acquisition strategy, and hiring a competent management team—they believe they can further scale their core operations to $100 million over the next five to ten years.

Company B is a larger, long-established competitor of Company A, looking to acquire Company A through a strategic acquisition. 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. 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.

Company A is open to selling and Company B believes this transaction will add significant value to their business over the next ten years.

The issue comes to price.

Company B is willing to pay the seller $52 million, but Company A believes in their company’s growth potential and thinks the business’ high growth prospects make the company worth $75 million.

In this example, the buyer still wants the business and the seller still wants to sell it. Ostensibly, the issue is in agreeing on a price that’s fair. 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.

Here is an example of how an earnout could be structured to reconcile this M&A deal and get the buyer and the seller to agree on a purchase price through the terms of the arrangement.

Company B (buyer) agrees to pay Company A (seller) $50 million up front, and if the business hits $100 million in five years, then they will pay the seller an additional $25 million ($75 million total), and if the business hits $75 million in revenue in that timeframe, then the seller will get an extra $10 million ($60 million total). If Company A doesn’t hit $75 million in revenue within the next five years, then the seller will only receive the initial $50 million.  

Is this earnout structure a good deal? From the buyer’s perspective or the seller’s perspective?

The rest of this guide will look at the earnout structure in this M&A transaction from both perspectives—buyer and seller.

Earnouts From The Buyer’s Perspective:

Building on the example above, we’ll look at this deal from the buyer’s (Company B’s) perspective.

Understand that this is obviously not a seller financing arrangement. The seller isn’t offering to let the buyer finance the additional purchase price with a seller note. This is in essence a hedging play. Company B doesn’t believe that Company A is going to hit its target of $100 million in five years and therefore is not worth $75 million.

The goal of Company B here is to mitigate the risk of overpaying for a business they are unsure is able to hit an aggressive revenue target. This makes sense for a lot of reasons. Maybe the management team isn’t capable of growing the business as effectively as the founders that will be bought out with this transaction. Maybe the management team will quit after the sale is complete. Maybe the economic climate will change in the next five years. Maybe increased competition will take more market share than expected.

In either case, Company B still has solid reasons to buy Company A. The risk comes in overpaying for the business. They use the earnout as a way to mitigate that risk by tying a percentage of the purchase price to those future targets.

One of the primary reasons that earnouts are employed in M&A deals is that the buyer wants the business but believes that the seller has an inflated opinion of what the business is worth.

Additionally, earnouts are often a good idea from the buyer’s perspective when they don’t believe the business will work as well without the founders. The buyer can use an earnout to tie the seller to the business, ensuring they won’t walk away entirely and leave the buyer with a business they don’t know how to run. If the owner is bound by an earnout agreement, they’re much more likely to help the acquirer hit its revenue targets. Sometimes earnout agreements are structured in a way that intentionally binds the seller (often the founder in this case) to a specific job role in the business (ie. leading the sales team).

Following this line of reasoning, from the buyer’s perspective earnouts can also be an important tool to ensure that management stays with the company through the sale of the business. Many of the assumptions the buyer makes about the company’s ability to grow are dependent on the people running it. Here, earnouts work as a sort of insurance policy against losing the management team they need in order to make the deal a success. Earnouts can be structured in a way that makes the earnout payment contingent on key employees staying with the business through the sale and into the future.

Earnouts also give the buyer the advantage of not needing to pay all of the purchase price for the acquisition up front. The earnout can be made contingent on targets that have a time period lasting years after the deal has closed. Only once the conditions attached to that longer-term target are met, will the buyer need to pay out the additional money. This is often a strategy that buyers employ in times when interest rates are higher than normal. Often buyers borrow money to facilitate M&A deals. An earnout means they pay less up front and therefore have to borrow less money at the higher interest rates.

Earnouts From The Seller’s Perspective:

The seller will have a different perspective concerning the earnout agreement. Many of the advantages from the buyer’s point of view are not advantageous to the seller of the business.

From the seller’s perspective, their goal is to maximize the payout they get in exchange for the business they’ve built and are now selling. If the buyer overpays, it’s bad for the buyer—but it means that the seller gets more money. Building on this we’ll look at some considerations from the seller’s point of view.

While the earnout is designed to tie a portion of compensation to the deal, provided the business exceeds its growth projections, the seller misses out entirely on that sum of money if the business doesn’t grow to meet those earnout targets. This is a major point of consideration for the seller (who has invested years in the growth of this successful business).

From the seller’s perspective, if the buyer does a poor job of scaling the business they buy, the seller is the one that loses out. From the seller’s perspective, this can seem like an unfair arrangement as the seller loses out if the buyer underperforms. The reality is that the founders understand their business better than the acquiring business does. The seller has no guarantee that the buyer will competently manage the business going forward. They must trust that the buyer is capable of growing the business to the target levels.

So, the principal drawback of all this is that the seller loses out on a portion of their compensation if the buyer can’t hit the projected growth targets of the business.

Legal Disputes & Earnouts:

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. Litigation often arises from these sorts of arrangements.

From the seller’s perspective, there is little they can do if the buyer misses the earnout target and they feel the buyer either intentionally missed the earnout target, or missed it due to improper management.

The reason is that the buyer will often want as much flexibility to operate the business they are buying, especially because the future is uncertain (economic changes, increased competition, employee turnover, etc.). Because of this, the buyer will likely be resistant to seller protective conditions or provisions. So, it’s not really feasible for the seller to set any standards of performance that the buyer needs to adhere to moving forward.

Earnout arrangements should always state how disputes will be handled. Often these agreements are structured in a way that both parties agree to an arbitrator to settle disputes, should any arise. The intention of this sort of provision is to avoid the costly litigation that can ensue from a dispute.

At a minimum the seller can ask the buyer for a legal obligation to operate the business in good faith. The seller should also include provisions for early pay-outs in events such as another sale (the buyer selling the business again). Also, if the earnout arrangement is tied to the retention of key employees, it should state that if the buyer decides to terminate those employees that this doesn’t interfere with the earnout agreement in a negative way.

What the earnout is contingent upon is also important. Generally, a seller will prefer to make the earnout payment contingent on the business meeting a revenue target. Revenue is harder to manipulate than EBITDA. If the earnout is contingent on maintaining EBITDA margins, the buyer has much more room to manipulate these than they do revenue.

It is always recommended that you work with a competent sell-side M&A advisor to assist in the negotiation and structuring of any earnout provisions.

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