PERFORMANCE ANXIETY? EARNOUTS CAN HELP
Performance anxiety? Earnouts can help
Given the current state of the U.S. economy, its not surprising that both business buyers and sellers are entering M&A transactions with increased trepidation. Buyers, in particular, are putting a greater emphasis on risk control, seeking to acquire targets as cheaply as possible and, in many cases, using earnouts to limit potential losses. These tools can also benefit sellers motivated to complete a deal now, instead of waiting for market conditions to improve.
Bridging the gap
An earnout sets a companys purchase price according to how well it performs after its sold. The buyer generally makes a down payment and several staggered payments over time based on the acquired businesss performance. Originally, earnouts were developed to retain key employees after a merger. These days, however, theyre more commonly used to bridge valuation gaps or overcome negotiation stalemates in which buyers and sellers disagree about the companys future profitability.
Buyers generally like earnouts because they ensure seller involvement during the transition period and require less money up front, thus reducing risk should the acquisition fail to meet expectations. Sellers like them because earnouts allow succession in phases while the seller participates in the sold companys future profitability.
Typically, earnouts base their price on one of three factors:
- Gross revenue,
- Net earnings, or
- An operational metric common in the industry, such as customer base size or sales numbers.
Sellers typically prefer gross revenue as a price basis because the expense management thats associated with net earnings is likely to be beyond their control. Buyers, on the other hand, commonly favor net earnings because it better reflects economic value. The number of variables involved in determining the bottom line, however, can lead to future disagreements. Operational metrics often offer a good compromise for both sides.
Minding the details
Whichever price basis you and the other party agree on, pay attention to what products and services are included when calculating the price. These can be the items that exist at the deals closing and those that may be developed in the future based on the sellers current offerings.
Earnout periods generally span between two and five years. Longer durations mean more information is available to compute the earnout. But as time passes, results may be more attributable to the acquirers business practices, rather than the original owners. Results also can be skewed by a temporary event such as a natural disaster or lawsuit that doesnt necessarily affect the operations long-term value.
The last thing either party wants is for their earnout to trigger a dispute down the road. Earnout discussions, therefore, should include potentially sticky post-transaction situations. For example, what if the buyer has products or services that compete with the selling companys, or if the buyer later acquires a competitor? Sellers should seek assurance that resources wont be channeled to other operations to artificially deflate the acquisitions performance.
Or what happens if the buyer wants to bundle acquired products and services with its existing offerings? This can make distinguishing revenues and earnings problematic, particularly if there are differences in marketing, price, production and distribution. Often, the best solution is to base the earnout on the combined businesss performance rather than that of the acquired companys.
M&A parties also should discuss what might occur if the buyer decides to sell certain assets that drive growth before the earnout period ends. In this situation, the seller typically asks the buyer to purchase the earnout at a mutually accepted price. Intellectual property ownership can be another source of contention if the seller continues to develop new products and ideas.
Finally, decide which accounting practices will be used to calculate the earnout price Generally Accepted Accounting Principles (GAAP) or another method and ensure the newly merged companys accounting system is set up to track this. Agree upon periodic reports, as well as the sellers right to inspect or audit the calculations.
Know your buyer (or seller)
Before agreeing to an earnout, both M&A parties need to ensure the agreement protects their interests and anticipates potential conflict. Earnouts typically shift some of the transactions risk to the seller, so sellers should fully investigate their buyers and may want to consider staying on in some capacity after the deal closes.