Earnouts have long been a major part of the M&A space, and they tend to be even more common when times get tougher. Earnouts give buyers some protection against an acquisition’s future underperformance, and allow sellers to enjoy a higher sales price if they can hit their projected numbers.
We expect earnouts to be a bigger part of the M&A landscape this year, so let’s talk about them!
What is an Earnout?
An earnout is an acquisition in which part of the purchase price is based on the company’s performance post-transaction. We can think of an earnout in two ways: a discount for the buyer if the target company underperforms, or a bonus for the company’s seller if it hits certain goals. Those goals usually center around revenue and profits, and tend to have a timeframe of two to five years after acquisition.
For example, a potential seller may claim, based on financial projections, that her company is worth $10 million. The buyer, less certain of those projections, values the firm at $7 million. The buyer proposes an earnout, in which they pay $ 7 million upfront for the acquisition, and the additional $3 million as an earnout. The other $3 million will be paid only if the firm achieves an average revenue of $6 million over the next three years, and profits of at least $400,000 each year.
Earnouts help to bridge the gap between what the buyer and seller believe is a fair price for the company. Naturally, most of a company’s valuation stems from expected future performance, particularly for younger, high-growth firms. Earnouts essentially guarantee some of that future performance “or your money back”.
Earn-outs also incentivize the previous owners to stay invested in the acquired company’s success, particularly if they remain part of the management structure after the transaction.
Suppose a founder agrees to stay on as CEO for two years after selling her company, in order to oversee the transition. She now may have a lower performance incentive, since she is no longer entitled to the company’s income and capital gains. To borrow one of Warren Buffett’s favorite phrases, an earn-out keeps “skin in the game” for both parties.
Tougher Times, Higher Bars
Generally, we can expect more earnouts when times get tough. In a risk-averse environment, buyers look for a more aggressive hedge against a deal underperforming expectations. While firms still have plenty of dry powder from the past few years, higher interest rates, and flagging GDP growth have shifted buyers towards certainty over speculation.
The last recession (excluding 2020) gives us some clues into how the M&A space would adapt to tougher economic conditions next year. The consensus is that earnouts will be a bigger part of 2023 than in recent years, transferring some performance risk to the seller.
According to M&A advisory firm Foley and Larper, 2021 marked the lowest rate of earnouts in over a decade; just 20%. Unsurprisingly, it also saw some of the highest earnings multiples in public and private equity. From 2012 to 2019, 26% of deals featured earnouts, a more typical figure for the past twenty years. In the years immediately following the Great Financial Crisis, about a third of deals included earnouts.
For all three time periods, risk tolerance was negatively correlated with earnouts. The firm notes, “As the hot seller’s market shifts to a market with more cautious buyers, the use of earnouts may grow in popularity.” For their part, Foley and Larper reported an increased incidence of earnouts in their own practice this year.
Overall, we expect earnouts to be a more frequent feature in M&A deals. We also expect profitability to receive greater consideration than revenue growth, as companies prioritize earnings quality over speculative growth plays.
Approaching an Earnout
Earnouts can rank among the most unpleasant parts of an M&A negotiation. It can frustrate a buyer if the seller won’t back its projections up by guaranteeing performance. “How can you justify this valuation if you won’t stand by the future performance you’re assuming?”
On the other hand, a seller may feel that having part of a sales price dangled overhead shows a lack of faith in the company, or even a lack of respect for ownership, particularly when the targets are very aggressive.
Rather than a sticking point, earnouts should serve as a bridge between the parties, helping to share a bit of the risk between them. The key is that earnout targets should be realistic, and should include a premium to compensate for the transfer of risk from the buyer to seller.
If all targets are met, the seller should ultimately pay a more than if there were no earnout provision, since it received a higher security of investment performance, insured by a discounted sales price if the purchased company underperformed.
Regardless of whether it features an earnout, any M&A deal should have a powerful virtual data room solution. In an earnout scenario, VDR’s provide segregated access to the documents needed to report and remotely verify financial performance, or any other KPI’s that the earnout depends on. VDR’s provide secure storage, efficient access, and precise permissions for the terabytes of sensitive data that a transaction involves.