In today’s COVID environment, many businesses have seen a significant change in performance, and uncertainty still exists regarding when businesses will see “a return to normal.” This fact, coupled with pent-up demand from baby boomers seeking an exit, is likely to lead to a significant increase in the use of earnouts in 2021.
For those unfamiliar with an earnout, an earnout is a way to structure an M&A transaction to defer part of the deal value, subject to the future performance of the business. For example, say ABC Company has $100 million in sales and $5 million in earnings. A potential buyer is willing to pay $30 million, but the current owner believes this undervalues the future growth prospects and asks for $50 million. To bridge the gap, the two parties can use an earnout. A compromise might be for an upfront cash payment of $30 million and an earnout of up to $20 million if sales and earnings reach a certain level within a one- to two-year window.
The example above uses sales and earnings for the target metrics, but earnouts can be written a number of ways, even based upon a particular sale closing or launch of a product. In most cases, the earnout period is less than three years. Further, earnouts are great in that both parties benefit from a successful outcome, and share the risk if things do not work out as hoped. However, earnouts are often half-jokingly referred to as “litigation magnets” so it is of utmost importance to structure these carefully at the onset. We have witnessed these go to litigation for issues such as disagreements about adjustments to earnings and sellers inappropriately discounting product (to make large sales to achieve earnout revenue targets, but leaving the buyer with no profit).
Don’t forget that if you are considering an earnout agreement with the purchaser of your company, you will still be working for a company you no longer control, and you are no longer making major business decisions. If the buyer makes risky or bad business decisions, your earnout is in jeopardy.
While GBQ has tax, valuation, and investment banking expertise across the M&A spectrum, including many transactions involving earnouts, a competent M&A attorney should be engaged early on in the process. Please contact your GBQ advisor for guidance.
Article written by:
Kelly Noll, CFA
Director, Valuation Services