Why earn out provisions are more prominent in Middle market M&A transactions?

Introduction

  1. Almost all M&A deals involve extensive negotiations between the buyer and seller.The buyer is focused not to overpay for the target business where as the founders of the target are looking to extract maximum money from the exit.
  2. Earn-out is one such provision which basically is used to bridge the valuation gap of the transaction from both buyer and seller perspective.The buyer values the target company post the business case and communicates the initial bid to the target in the Letter of Intent.The seller parallely would also have valued his business based on its historical and future projections.There is a higher likelihood that the final valuation or Enterprise value of the target business would be different for the buyer and seller.The buyer would have taken a conservative approach on the optimistic projections forecasted by the seller and would have valued the business at lower value where as the seller would be highly confident of its future projections and therefore would demand a higher valuation.
  3. This results in extensive negotiations between the buyer and seller.In order to resolve this deadlock, the buyer can introduce an earnout provision in the final purchase price where a part of the purchase price would be paid in a future date contingent to the fulfillment of financial/operational milestones.Most of these milestones metrics are Financial based like annual Revenue targets, EBITDA targets, growth rate and cumulative revenues to be achieved by the seller during the entire earnout period.
  4. In most of the cases, buyers generally include an earnout provision to ensure the target management continues to be involved post acquisition.This shall help the buyer to achieve a smoother transition and also help in integrating the target business with the acquirer. As founder would continue to be involved in the business, the seller would also ensure that its key employees does not leave the company post acquisition. Exit of the key employees would dramatically reduce the chance of a the seller to achieve its earnout.

How Earnouts are structured

  1. Before deciding to structure an earnout, the buyer should decide the underlying reason to have an earnout provision in the purchase price agreement.If earnouts are included for strategic reason to ensure the seller and its key employees are retained till a specific period post acquisiton, then the buyer can allocate not more than 15% of the final purchase price as an earnout.
  2. If including an earnout is for financial reason where the buyer is not confident of the future cash flows of the target business based on the target evaluation of its business then around 40-50% of the purchase price can be provisioned for earnouts.This is to ensure that the buyer does not overpay for the target business in event of the target business performing badly in future.

Some of the components in an Earnout calculation in Final purchase price would include

  • Headline purchase price – This is the maximum purchase price that the buyer is ready to pay for the target business.In most of the cases this price is based on the seller valuation of its business.In some cases the buyer can negotiate this and can arrive at 80-90% of the seller valuation.
  • Upfront payment – This is the price the seller receives when the deal is closed.
  • Contingent payment – This is the difference between the Purchase price and Upfront payment and is paid contingent to the achievement of revenues/operational targets devised by the buyer.
  • Earnout period – This is the time duration where Earnout provisions are accounted for.Most of the cases, the earnout period varies between 1-5 years.
  • Earnout calculation metric – This is primarily the metrics used to arrive at the milestone payments.The milestone payments can be paid to the seller annually or be paid as a bullet payment at the end.In addition, earnout payments cannot be binary, for instance if the seller is not able to achieve the targets, then he cannot be entitled to zero payments.In most cases, target percentages are kept where the seller would receive payments subjected to the achievement of the percentage of the final target.For instance, If the seller achieves 90% of the revenues targets then he is entitled to 80% of the earnout payments for that year.

Why Earnout payments can be a topic of disputes?

  1. Even though Earnouts provisions are included to ensure that both the buyer and seller have a win-win proposition, yet most of the earnout payments end in disputes with some even going to courtrooms.
  2. The primary reason for the dispute would be how the target business would be run post acquisition. Prior to the acquisition, the seller had full freedom to run its business according to its requirement.Post the acquisition, the buyer is in charge of the control, hence seller business might not be able to run the business in a way to achieve his milestone payments.
  3. In addition to that, how earnout payments are measured and accounted also varies.If the earnout payments are EBITDA specific, then the buyer can add additional overheads to the target earnings which can lower the EBITDA targets.
  4. The earnout targets also make the seller myopic in its approach and shall not focus on the long term growth of the business.The buyer might want to discontinue some of the client relationships or some service offerings that are no longer relevant to its business, but the seller would resist as this would affect its earnout payments.
  5. Macroeconomic situations like recession or client concentration risk can also impact the target ability to achieve earnout targets.Though these issues are not limited to the target business and would impact the overall industry, the seller should try to negotiate on its earnout payments taking into account these external factors.
  6. Tax structure of the earnout payments should also be negotiated between buyer and seller.In some jurisdictions, the earnout payments are taken as goodwill and deductions happen accordingly where as in other instances, earnouts are valued at fair values to arrive at tax implications. In accounting terms, earnouts are taken as deferred revenue and in some cases, they are recognized only when they are accrued. All these factors needs to be considered.
  7. Buyers also reduce the earnout payments based on an indemnification claim on a warranty breach.This is generally called a set off rights where the buyer can holdback a part of earnout payments to be paid to seller.The seller should negotiate it by either reducing the amount held in the escrow amount or not include the set off rights in the agreement.
  8. During the earnout period, the buyer may sell the target business.In this case the seller should demand that his earnout amounts be accelerated or he should receive a stake in final proceeds of the sale.

Conclusion

  1. Earnouts are becoming prominent in the final purchase price agreements in middle market M&A transactions. It is a powerful tool to ensure both the buyer and seller get benefits out of the transaction.
  2. Structuring an earnout and how the milestone payments would be measured and when will it be received would form a core area for negotiations. It is better to include a seasoned M&A practitioner along with a legal counsel so that the key terms of the earnout clauses are drafted in a simple way that is understood by both the parties.
  3. If earnouts are structured, drafted and executed successfully, then this can be a good approach for the buyer so that it does not overpay for the the deal, retain seller management thereby able to integrate the target successfully and realize the necessary synergies


Leave a Reply

Open chat
Powered by