Why It’s Easier to Succeed With Structuring Earn-outs In An M&A Transaction Than You Might Think

Structuring Earnouts in an M&A Transaction

In an M&A universe, deals get concentrated into two components: valuation and risk allocation. Many strategically accretive transactions to both companies fail to get consummated for variances in the ascribed estimate or for the inadequacy of the buyer to alleviate risk. In other cases, structuring earnouts in an M&A transaction has bridged gaps among two different companies to significant effect, through various forms of deferred and contingent payments.

As theoretical theories, both valuation and risk get rooted in the future free cash flows of the target business. The inferred threat gets buried within the relative uncertainty of these future cash flows.

Sadly, but usually, exogenous factors in a vibrant marketplace enhance the relative uncertainty around future cash flows to accelerate both buyer and seller judgments on valuation outside the zones of agreement. When this happens, contingent forms of payment, which include earnouts, escrows, holdbacks, usually serve the only possible tools to crack the negotiations impasse.

An earnout is a contractual agreement connecting a buyer and seller in which a part or all of the purchase price gets paid out contingent upon the target firm delivering predefined financial and operating milestones post-transaction-close. Earnouts bestow a series of advantages to those who employ them.

Advantages to both parties:

Break purchase-price standoffs among buyers and sellers; Win difficult discussions among the selling or lasting management team and the buyer about how the asset will get operated post-acquisition.

Advantages to buyers:

Decrease the quantum of capital at risk at the time of transaction-close; Enable the buyer to secure the fair market value of the target on its achievement and not an emotion; Displace the risk of post-merger/acquisition underperformance from the acquirer to the seller; Build a source of alignment and retention for the target firm’s surviving management team by providing them winning, milestone-based time and performance incentive packages tied to post-acquisition results;

Give an efficient deferred financing tool that may enable undercapitalized buyers to obtain an attractive target with time still to link the outstanding capital requirement.

In most situations, the buyer can partly pay for the acquisition of profits from the target firm. Low-quality target firms are usually hesitant to admit this kind of structure given that the target firm’s management understands the earnout has a moderate probability of success, and Allow the target asset to justify its value.

Advantages to sellers:

Support an aggressive sale price, should say seller be prepared to earn it — a purchase price that would generally be unattainable at the then-current discounted cash flow valuation evaluated by the buyer.

The Downside to Earnouts

As with most structured finance explications, there also exist some distinct limitations to earnouts. One would be the potential for a lawsuit in the space between transaction-close and the earnout’s closing. Although in philosophy, earnouts regulate the concerns of both buyer and seller to post-acquisition financial and operating benefit, there are numerous areas where interests, plans, and inclinations; however, differ.

The most popular of these is how the target firm will get run en route to realizing the jointly agreed-upon targets. This hurdle is most prevalent where the acquired firm becomes a member of more significant business and strategy and required to operate separately from how it did as a standalone business.

Structuring Earnouts in an M&A Transaction — A Case Study

Let us build a case study that will help reproduce and demonstrate how to structure an operative earnout. It is as follows:

An acquirer has conducted an in-house strategic review and inferred that it sustains a vital product gap. Its competitive landscape has developed such that its customers presently favor one-stop-shop solutions that cover Product A, which it does not currently offer. The speed to market is crucial in the buyer’s platform. As it has an excellent understanding of its competitive landscape, it opts to acquire a startup, Firm B, which concentrates on Product A.

NDAs and financial and operating data start to get transacted in a data
room.

Based on the data provided, the acquirer values the startup firm B at EV of $4M, whereas the firm B values its company at EV of $16M.

Negotiation

In the negotiation, the buyer tells that Firm B has only one year of financial records and that, though successful, they are still to demonstrate that they can seize market share from other competitors.

Conversely, Firm B illustrates that Product A — powered by licensed, exclusive technology (lower cost) is adequately differentiated from other products in the market to not only gain share but generate further demand. Firm B’s viewpoint is that this will accelerate revenue growth at rates well over industry standards.

After days of negotiations, both firms find themselves in a purchase price stalemate without an adjustment.

The buyer recognizes the strategic importance of obtaining the ability to build Product A as soon as possible, and it opts to create an earnout structure that bridge the valuation gap, made by its future cash flow anxieties and thus breaking the negotiation impasse.

Structuring Earnouts in an M&A Transaction — Crucial components

The subsequent segment studies at each of the crucial
components to examine when structuring an effective earnout: (1) Purchase price, (2) up-front payment, (3) contingent fee, (4) earnout time, (5) performance metrics, (6) Payment methodology, and (7) Contingent payment method.

Purchase price: The fundamental action is to ascertain the total amount the seller will get. If the buyer understands the seller’s ask and needs to sustain a dominant negotiating stance, then most usually, the buyer initiates the total purchase price according to the seller’s ask. This stance beacons to the seller that the buyer is agreeable to link the whole valuation gap and enables the seller to earn the purchase price asked.

Up-front payment: The next move is to decide what part of the total purchase price will get paid at the transaction closing. From a buyer’s aspect, the maximum value of the up-front payment should meet his estimate of EV. The upfront payment is a variable of highest importance given it outlines the buyer’s capital-at-risk — i.e., the money that will get written off should the target underperform so significantly that its EV appears in more economical than the upfront payment. Usually, buyers want to derisk the deal by reducing the up-front amount under their computation of enterprise value, narrowing the risk.

Contingent payment: The third move is to define the contingent amount, where the contingent fee is the total purchase price less than the up-front payment.

Earnout period: The fourth step is to ascertain the earnout time. Earnout periods typically have a span of within one to five years, with a standard of three years. In reality, the earnout period should be adequate to render the surviving management team ample time to accomplish their goals but not so long as to produce “goal fatigue.”

Performance metrics: The fifth step is to define the performance metric to assess the target firm’s performance. Such parameters need to be jointly agreed upon, well known, clearly established, and easily measured. There are two kinds of performance metrics, financial and operational. Financial metrics are typically revenue or EBITDA based. The income gets used when the target firm is wholly integrated into the buyer, causing it extremely challenging to estimate the standalone profit profile post-assimilation. And EBITDA is used when the target firm will remain to get operated as an autonomous entity with its own set of independent financials. Operational parameters get typically calibrated by milestones and are most prevalent in technology companies where new product development can significantly enhance the EV of the target firm.

Measurement/payment cycle: The sixth step is to define the measurement and payment frequency. There are two common possibilities in this regard: (1) multiple, staged payments, performed annually, and (2) a single bullet payment, typically after the earnout period. As an M&A advisor, I will recommend against the multiple payment methodologies because its method usually comes with ample stress and distress for management. At the same time, it is customary for the seller to favor smaller and more regular milestones and payments to alleviate the unfavorable outcomes to their operating risk.

Target metric and contingent payment method: The ultimate step is to define the target metric (i.e., the level of performance) and the payment price for such a level of performance. The earnout structure should give premia for partial achievement by the target firm, even if it does not wholly adhere to its performance goals.

Decreasing the Downside Risk

Frequently buyers and sellers concur on a price; though, buyers recognize exogenous risks, which could put downward stress on the target firm’s performance and view to structure earnouts to shift the risk of underperformance to the seller. The most common exogenous risks, I have seen in my clientele are recession worries and client concentration.

Conclusion

The rigor of mergers and acquisitions is a complicated and twisted one, peppered with its part of false starts, exciting pursuits, and tragic shortfalls. The failures to consummate deals, notwithstanding months of diligence and prep, following on both sides, and an even enthusiasm to generate value usually spring from unresolvable disputes around valuation or the failure of one or both parties to alleviate risk efficiently.

Earnouts, though usually tricky to negotiate, are means to both break purchase-price standoffs and reallocate risk.