Earn-outs are starting to appear more broadly in deals as a result of the uncertainly caused by the COVID-19 pandemic. An earn-out can help two parties reach a consensus on the purchase price by incentivizing performance during a post-transaction transition period. Earn-out deal mechanisms generally require certain goals be reached in order for a price point to be paid. These goals might be based on the performance of the combined entity, performance of a stand-alone business unit, or overcoming of a regulatory hurdle.
Earn-outs can de-risk a transaction from the buyer’s perspective and reduce the need for more upfront capital to close a deal. From the seller’s perspective, an earn-out may afford some participation in the upside post acquisition, or be an opportunity for existing management to stay with their baby through the transition period.
Over the years, use of earn-outs in deal-making has waxed and waned depending on market conditions and expectations from the interested parties. They appear to becoming more common in the current environment because of the disruption to financial performance many organizations have experienced over the past nine months and the unknowns about when travel restrictions and other ramifications from the COVID-19 pandemic might be resolved. The M&A market also continues to favor sellers because there are fewer organizations looking to sell than parties interested in the strategic buy, so incorporating an earn-out into your transaction deal may help buyers get their deal to the finish line.
Structuring or analyzing an earn-out requires considering a number of characteristics of the deal, colloquially initialized here as STRIPE:
The relative size of the buyer versus the seller will greatly affect pricing decisions. There are three combinations to consider:
- Large Buyer / Large Target or Small Buyer / Small Target (“Large-Large” or “Small-Small”)
- Large Buyer / Small Target (“Large-Small”)
- Small Buyer / Large Target (“Small-Large”)
A Large-Large or Small-Small deal generally comes from a desire to increase market share in underserved areas, or when each has a complementary division implying some sort of marketplace synergy. Each well-established entity might find an earn-out desirable as sort-of a ripcord if relations dissolve. Also, with the even bargaining power of two entities, both parties might support the notion of keeping powder dry until success is more certain.
A Large-Small purchase might involve the Large entity bolting on a specialized service entity, where the Small management team staying on is critical for the success of the venture. Additionally, the Small management team might see much greater upside associated with being acquired by a Large entity, and as a result not want to settle for an immediate buyout and exit. The Large entity might have questions around the Small entity’s ability to deliver to scale considered in the original negotiations, and as such, an earn-out de-risks the acquisition.
A Small-Large purchase comes with a variety of complex issues, but as it pertains to purchase consideration, the basis for an earn-out could simply be the lack of access to capital or the expense of the capital required to complete the transaction with a single payment.
The above considerations are agnostic to market conditions and more tied to sentiment and available buyer capital.
Earn-outs come with measurement dates, or a time period at which performance is reviewed for success or failure relative to the criteria established. We generally do not see earn-out periods of less than a year or greater than five years regardless of acquisition size. Measurements are either point-in-time performance versus a metric, or a look-back at cumulative earnings over a given period versus a benchmark.
Acquired targets may have been found through a financial intermediary or as a result of a long-standing relationship. Vendors may be purchased as part of a vertical integration strategy, and after many years of continuing service. As a result, an earn-out may be used to de-risk a transaction where the two parties have short to no history with each another. An earn-out might be less desirable when vertically integrating an existing relationship, since the parties will have had time leading up to consummation of the purchase to settle on a price and pro forma.
Measurable, reliable performance data is necessary to perfect an earn-out. Certain industries are more conducive to measuring a financial metric, like revenue, versus others where deferrals and other considerations might muddy the waters. Sales cycles are an important factor also. A heavily contract-based business, such as waste management, may make earn-outs less risky, since a larger portion of the revenue is predictable. Companies with wild seasonality or sentiment swings, or that involve the sale of goods or services over longer time scales, might make for less ideal earn-out candidates. It really depends on the metric used to establish the earn-outs. We have seen instances where industry drives the metric. For example, a cable or wireless company might have an earn-out based on number of customers or transmission poles, whereas a pharmaceutical company may use FDA approvals. A host of other non-financial metrics are available to trigger payouts depending on the industry.
If the STRIPE acronym could be made in order of importance, this would be first letter. An earn-out’s structure is directly tied to the buyer’s and seller’s interests. If the parties are extremely amicable, then the earn-out metric may be tied to a reasonable growth goal as opposed to a stretch goal. The earn-out period might be shorter as well to cover some initial transition period. If there is trepidation on the part of one or more parties, then the earn-out might be a little more stretch goal-based and longer term in nature. It is critical to the structuring or analyzing of an earn-out to understand this aspect of the deal.
The parties to a transaction may not have similar expectations regarding the outcome. Having an understanding of each party’s expectation, and the ability to compare and contrast those expectations is key to both arriving at a reasonable structure for the earn-out and analyzing the value of the earn-out. If you are looking at an earn-out on-the-run after the deal has been put in place, understanding how expectations may have changed and the driver behind those changes is critical to understanding its value.
How Earn-Outs are Being Used Today
An earn-out may also be able to mitigate one of the biggest issues in the current deal environment: revenue uncertainty. Some companies are optimistic that earnings can be confidently projected while others are still reframing their strategy and possibly even the nature of their product depending on what sectors of operations have been affected by the COVID-19 pandemic. Performance targets can be modeled to be highly ambitious, but generally realistic performance measures are the determining factor in how earn outs are set and used today.
In this unique environment, there are some other trends emerging around the structure of the earn-out that may help buyers with their evaluation about whether to include such a provision in their transaction.
- Few long-term earn-outs. Sellers do not want to sign up for three-year earn-out periods.
- Buyer agreements. The seller will promise revenue goals for the remainder of the year.
- Sellers retaining leverage even during COVID. There are not enough sellers in the market to provide buyers previous negotiating power.
Assigning Values to Earn-Outs
Oddly enough, as much as the type and structure of the earn-out varies from deal to deal, the process for estimating the value for an earn-out deal-to-deal has become more standardized. Market fluctuations and unforeseen financial circumstances may very well persist in the short-term, but there is detailed, industry-accepted information available on how to value earn-outs in this uncertain market.
Working with an advisor who is experienced with setting values for earn-outs may help illustrate the structure most advantageous for your deal. For more information, please contact a member of our team.
Published on October 29, 2020