By Alastair Church
If and when you sell your business, in an ideal world you would expect to receive a single cash amount on closing. There might be some sort of limited holdback or escrow, but otherwise the deal would be clean and simple. This is the case for most company sales, but occasionally we encounter deals where there is an “earnout”, most commonly involving a trade buyer.
So, what exactly is an earnout and how does it work? In its simplest form, it’s a type of deferred consideration which is contingent on future events; it is a contractual commitment that provides an opportunity for sellers to achieve additional compensation from the sale of a business. The release of this additional compensation is tied to the achievement of pre-agreed milestones or targets, often linked to financial performance of the business. In practice this means that the sellers receive further payments after the sale is completed if the business continues to perform as expected or even outperforms.
There is no set formula for working out what value or shape the earnout should be. Every business is different and the earnout should reflect that. For example it could be a lump sum that is paid out on achieving a targeted EBITDA level, or a percentage of future revenues that is paid out over the next 2-3 years. In the general market, earnouts are often linked to profitability (usually EBITDA), whereas in the technology market they are more commonly linked to revenue growth targets or to technology milestones, such as completion of defined stages of the technology roadmap.
Why are earnouts used?
Trade buyers often try to include an earnout in their offer for a business as a way to make it look more attractive by giving it a higher headline valuation. In the SMART processes that we run for our clients, we actively discourage this by using competition among the different bidders to force them to put their very best offers on the table. Cash on completion is best, and we make it clear that uncertainty about valuation in their offers will be viewed negatively, to the benefit of other bidders in the process. But occasionally, usually only after a closely fought auction, we find that the winning bidder has been able to put a higher total price on the table by adding an earnout, which our client has accepted.
6 key things to be aware of:
Get advisors on board: Earnouts can be exceedingly complex, so it is essential to have experienced corporate finance and legal advisors on board before the negotiation phase in order to appropriately structure the earnout package if that arises. There can be significant tax consequences too, so it’s even more important to take specialist tax advice before the deal completes.
Avoid overcomplication: Having lots of complex targets surrounding the earnout could jeopardise the way it works and increase the risk of future disappointment for the sellers if it doesn’t work out as planned.
Don’t lose sight of the key objective: Don’t let the earnout negotiations take over the deal and become a potential block to it happening or becoming “the tail wagging the dog”. It’s important to keep a sense of perspective about what is really important for your interests as a seller from the deal and what is merely a “nice to have”.
Agree achievable targets: Defining the milestones and what constitutes success can be very difficult. Both sides need to be happy with them today and in the future. Keeping targets within the expectations of the business will protect against a failed earnout, a frequent result of unattainable targets.
Spend time on structure: An earnout needs to be structured in way that aligns the key stakeholders so that successful completion of the earnout period will be positive for all parties. Note that this can be more challenging when the sellers are not part of the management team following the sale, which is not uncommon.
Know your value to the buyer: If the buyer wants to integrate the business quickly following the acquisition, an earnout is probably not a suitable mechanism. The need to measure the metrics against performance makes it very hard to integrate a target company, meaning it is difficult for buyers to realise the strategic benefits of an acquisition until the earnout is over.
An earnout can be an important part of an M&A process. Careful negotiation of the terms is essential for success. To discuss your transaction requirements, get in touch with the FirstCapital team.