An earnout is a type of pricing formulation found in M&A whereby the buyer agrees to pay an additional amount of the purchase price to the seller if the seller can attain specific performance milestones within a defined period following the deal’s closure.

Earnout provisions usually occur in deals where the seller and the buyer can’t agree on the current value of the target business.

In this article, we’ll outline how an earnout provision works, the benefits and risks of an earnout payment, and some earnout best practices and due diligence for effective earnout clause negotiation in M&As. Keep reading.

 

Structure and Types of Earnouts

With earnout provisions, the buyer essentially agrees to pay an upfront purchase price for the target business based on what they think it’s worth or what they’re comfortable with at the time. 

However, if the business ends up performing better than expected — specifically by achieving specific performance targets —  the buyer will then pay an extra earnout payment amount. The performance targets or metrics used to structure an earnout provision can be financial, non-financial, or both.

 

The most common financial metrics used in earnouts are:

  • Net revenue
  • Net income
  • Earnings before interest and taxes (EBIT) 
  • Earnings before interest, taxes, depreciation, and amortization (EBITDA)

 

Common non-financial metrics used in earnout clauses include:

  • Regulatory approval (e.g., a pharmaceutical company securing FDA approval for a new drug)
  • Obtaining a major contract from a new customer
  • Reaching a specific number of customers
  • Successfully introducing a new product

 

Advantages of Earnouts

If properly structured, an earnout contingent payment can bring several benefits to both parties in an M&A.

 

Bridging Valuation Gaps

The most common reason for including an earnout clause in an M&A deal is to bridge a valuation gap. A valuation gap arises when a seller wants to sell a company for more than a buyer is willing to pay for it.

Let’s consider a scenario where the seller values their business at $50 million, but the buyer insists they cannot reasonably pay more than $40 million for it outright. The deal is unlikely to move forward with such a huge disparity in valuation.

However, if the buyer agrees that a higher valuation might be justified if the target met some future performance goals, the two can reconcile their valuation difference with an earnout contingent payment.

They could then settle on a specific performance goal or target and then craft a formula for calculating the earnout.

For example, the buyer could agree to make a fixed payment of $40 million and then an additional payment later if the target’s EBITDA exceeds a threshold of $10 million over a one-year period after the deal’s closing. They could set the extra amount to be paid at two times the difference between the actual EBITDA and the set threshold. 

So, if the acquired company realizes an EBITDA of $15 million over the course of a year, its owners would receive an additional $10 million from the buyer. That means  $50 million in total, which was actually their original valuation.

That’s the magic of an earnout clause. It can help bridge valuation gaps and helps avoid a deal being killed.

 

Hedging Risk

An earnout clause can also help hedge risk, particularly for the buyer.

Say the buyer believes the target’s valuation but is concerned about the latter’s ability to meet a certain performance goal, on which their valuation is partly based on. The goal could be something like gaining regulatory approval for a new product, securing a patent, or signing a major client. 

In such a scenario, the buyer can insert an earnout clause in the deal. The earnout protects the buyer by withholding a portion of the purchase price and only completing the payment if the promised goal is met. 

 

Retention of Key Managers

Earnouts can also facilitate the retention of key managers and personnel who are also shareholders in the acquired firm.

Since some part of the purchase price is contingent on certain performance goals, after the deal’s closure, the target firm’s managers will have the incentive to stay with the company so as to partake in potential future payments from the acquirer. 

 

Potential Challenges and Considerations of Earnouts

Although earnouts have several benefits, they also have a few shortcomings. Here are a few notable ones.

 

Integration Issues Post-Deal 

Earnouts are likely to be ineffective if the target integrates with the buyer completely. That’s because the more the buyer integrates the operations of the target into its own, the less control the management of the target will have over achieving the set performance goals.

Typically, in an integrated entity, key decisions concerning revenue, profit, and expenses may need to be made to benefit the combined entity rather than just the target. This could demotivate the management of the target or lead to conflict between the two parties.

The solution to this problem is to select performance targets that won’t be adversely affected by the post-merger integration or simply provide the target with operating independence during the earnout period.

 

Complexity and Uncertainty 

Some of the definitions and performance standards set in the earnout clause may be difficult to administer post-closing. Also, some of the results may be difficult to measure, or the buyer and seller may have differing views on how to measure them, leading to disputes.

 

Prioritization of Short-term Goals Over Long Ones 

If the management team of the target firm remains, they may prioritize or focus solely on meeting the earnout targets at the expense of the firm’s long-term interests.

Also, if the earnout is based on revenue, the target company’s management may pursue unprofitable sales just so they can meet their earnout target.

 

How to Negotiate an Earnout Clause

Here are a few best practices for effective earnout clause negotiation.

 

Step 1 – Define Clear and Measurable Targets

The targets set for the earnout clause should be precise, unambiguous, and, most importantly, measurable. Clear and measurable targets leave no room for misinterpretation, allowing both the buyer and seller to have a common understanding of what exactly needs to be achieved and by how much.

For example, instead of setting a vague target like “increase revenue,” it’s better to define a specific target such as “achieve a 10% increase in annual revenue within the first two years after the acquisition.”

In this example, the target is clearly defined and measurable. The specific metric used is annual revenue, and the target is set at a 10% increase. That means that the seller will be eligible for additional compensation if the business receives a 10% growth in revenue within the designated time frame of two years.

 

Step 2 – Establish a Realistic Earnout Period

The typical earnout duration is one to five years. However, the right timeline will vary from one deal to the other.

The earnout period you set should be realistic and aligned with the nature of the business, the industry, and market conditions. At the very least, it should allow sufficient time for the acquired firm to demonstrate its value and meet the earnout targets. However, it shouldn’t be too long that it interferes with the buyer’s long-term strategy and plan for the acquired business.

Collaborative discussions between the buyer and the seller, with the assistance of legal and financial professionals, can help determine a realistic earnout period that’s satisfactory to both parties.

 

Step 3 – Integration and Post-Closing Support

Integration and lack of post-closing support can disrupt the seller’s operations and hinder their ability to meet the agreed-upon targets. To avoid such a scenario, it’s vital to create a clear plan for how the two firms will operate after the deal is finalized. This plan should outline how they’ll integrate their operations.

It should also state the type of support the buyer will provide. For example, the buyer should commit to offering or sharing the necessary resources, including financing, expertise, mentorship, and guidance, to assist the acquired company in meeting the earnout targets.

 

Step 4 – Seek Professional Advice

Given the complexities of earnout clauses, seeking professional advice from legal and financial advisers is highly recommended.

They can help with several facets of the negotiation. For example, professionals can help determine an appropriate earnout period, define realistic performance metrics, structure earnout payments, and develop a comprehensive integration and post-deal plan. 

Additionally, they can anticipate potential issues or disputes and offer recommendations on how to address them effectively.

 

Final Thoughts

If you’re planning an M&A deal but can’t agree on the purchase price or have different perspectives on the value of the deal with the second party, an earnout clause can help you bridge the valuation gap and allow you to close the deal.

If you’re the seller, an earnout means additional payments if your business does as well as you expect it to. And if you’re the buyer, you can avoid losing out on a great and attractive target just because of valuation differences.

Keep in mind, however, that there are some risks and challenges that come with earnouts, such as integration issues post-closing.

Weigh the benefits against the risks, and consider your specific circumstances to determine whether negotiating for an earnout clause is the right move for your firm.

Finally, a virtual data room (VDR) can be a valuable tool to have when negotiating for an earnout clause in M&A. A VDR, like CapLinked, can help streamline the process by allowing fast and secure storage and sharing of relevant documents with all parties involved.

 

To see how CapLinked can help you in your next M&A deal, sign up for a free trial.

 

Sean LaPointe is an expert freelance writer with experience in personal and business finance. He has written for several well-known brands and publications, including The Motley Fool and Angi/HomeAdvisor.

 

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