Previously we reviewed the leading killer of M&A transactions—poor financials.[JB1] Today, we’ll shift gears and talk about earn-outs, a M&A concept that can help save deals.
What Is an Earn-Out?
When I represent sellers of businesses with a track record of generating consistent revenue and cash flow, buyers will generally pay the vast majority of consideration in cash at closing. However, in certain cases the business may be at an inflection point, or may have been significantly impacted by COVID, and buyers and sellers can’t agree on the value of the company. In these scenarios, they may employ a strategy called an “earn-out.” An earn-out is a contingent payment that the seller receives from the buyer if specific performance targets are met.
When Is an Earn-Out Utilized?
We are currently representing a seller in this precise situation. Our client experienced hyper-growth in 2020 and 2021, fueled by COVID-related projects. In 2022, their COVID-related work has been completed, but is expected to be fully replaced over the next several months by new, contracted non-COVID work. You can see why the buyer and seller here may have differing views on risk and value!
In this instance, the buyer and seller have agreed to a deal structure where the seller will receive part of the valuation in cash at closing and the remainder within several months of closing, assuming the new projects commence and generate the expected financial contribution. Further, the seller has an opportunity to earn significantly more than the base valuation if they exceed specific targets. Our seller likes this structure, as they have tremendous conviction about the near future and will be empowered to run the company in the same manner as they do today. The buyer likes this structure as a hedge against their risk of overpaying. Sounds like a win-win, right? Read ahead, as the devil is in the details!
How Do You Structure an Earn-Out?
While the high-level earn-out structure is reasonable to both sides, the specific terms become incredibly important. Here are a few terms to consider as you work closely with your advisors:
- Financial Metric: Which metric will be used—revenue, gross profit, EBITDA, etc.? Sellers prefer to use revenue and buyers prefer EBITDA or Net Income.
- Definition of Metric: Regardless of which metric is employed, it must be well defined and include the accounting treatment to be used (e.g., GAAP). We recommend including specific examples in the agreement for clarity.
- Time Horizon: How much time does the seller have to achieve the target? When will the earn-out payment be made? Sellers prefer a shorter time frame and buyers prefer longer.
- Results Verification: How will results be verified? Which parties will be responsible for validating results? Is an audit required? What is the resolution process if parties don’t agree?
- Tax Efficiency: Is the earn-out structured in a tax-efficient manner for both parties? Who receives earn-out payments—the seller’s entity, or the seller personally?
- Seller’s Role, Compensation, and Level of Autonomy: Is the seller fully empowered to run the business as they see fit? Will they be compensated fairly and have the expected level of autonomy?
Against the background of COVID-19, our rapidly shifting economy, and ongoing political uncertainty, we expect earn-outs to become increasingly utilized in M&A transactions to bridge differing views of valuation. If both parties agree to utilize an earn-out, we recommend that the earn-out be structured as simply and concisely as possible; be drafted so that both sides reap clear benefits; and that investment banking, tax, and legal experts be brought into negotiations as early as possible, given the various complexities that earn-outs may introduce to a deal.
As you consider selling your business, we encourage you to speak with us. Kinected Advisors has an 84% success rate in our transactions, well above the 20–30% industry average. We can help you get the best possible deal for your business.