- July 28, 2022
- Posted by: Ramkumar
- Category: Posts
Earn-out in Mergers And Acquisitions
Does earnout in mergers and acquisitions work?
In M&A deals, especially in private transactions, 𝗲𝗮𝗿𝗻-𝗼𝘂𝘁 𝗶𝘀 𝗮𝗻 𝗲𝘀𝘀𝗲𝗻𝘁𝗶𝗮𝗹 𝗽𝗼𝘀𝘁-𝗰𝗹𝗼𝘀𝗶𝗻𝗴 𝗮𝗱𝗷𝘂𝘀𝘁𝗺𝗲𝗻𝘁 on the purchase price to bridge valuation differences between the buyer and the seller. As a result, the 𝗲𝗮𝗿𝗻-𝗼𝘂𝘁 𝗽𝗲𝗿𝗶𝗼𝗱 𝗮𝗻𝗱 𝗺𝗶𝗹𝗲𝘀𝘁𝗼𝗻𝗲 𝗽𝗮𝘆𝗺𝗲𝗻𝘁𝘀 𝗯𝗲𝗰𝗼𝗺𝗲 𝗮 𝗻𝗲𝗴𝗼𝘁𝗶𝗮𝘁𝗶𝗼𝗻 𝘀𝘂𝗯𝗷𝗲𝗰𝘁 between the parties. The buyer thinks it is hedging its risk and is thus willing to overpay for the deal because if the target does not perform, it will not get earn-outs.
In my experience, earnout metrics focus on EBITDA, though, in a few deals, i have observed buyers use revenues as a metric.
However, 𝗲𝗮𝗿𝗻-𝗼𝘂𝘁 𝗱𝗼𝗲𝘀 𝗻𝗼𝘁 𝘄𝗼𝗿𝗸, if there are synergies in the deal and the buyer has paid a premium to realise synergies. In addition, after the deal closes, the 𝗯𝘂𝘆𝗲𝗿 𝗮𝘀𝘀𝘂𝗺𝗲𝘀 𝘁𝗵𝗲 𝗲𝗾𝘂𝗶𝘁𝘆 𝗰𝗼𝗻𝘁𝗿𝗼𝗹 𝗼𝗳 𝘁𝗵𝗲 𝘁𝗮𝗿𝗴𝗲𝘁. In contrast, the seller wants to take control of the daily operations until the earnout period. Suppose the buyer keeps the seller independent until the earnout period. In that case, it delays any synergies realisation (cost cutting, market access for revenues synergies) for which it had paid a deal premium.
This 𝗰𝗼𝗻𝗳𝗹𝗶𝗰𝘁 𝗶𝗻 𝘁𝗵𝗲 𝗶𝗻𝘁𝗲𝗿𝗲𝘀𝘁𝘀 𝗯𝗲𝘁𝘄𝗲𝗲𝗻 𝘁𝗵𝗲 𝗯𝘂𝘆𝗲𝗿 𝗮𝗻𝗱 𝘀𝗲𝗹𝗹𝗲𝗿 𝗱𝗲𝘀𝘁𝗿𝗼𝘆𝘀 𝘁𝗵𝗲 𝗱𝗲𝗮𝗹’𝘀 𝘃𝗮𝗹𝘂𝗲. Thus, rather than allocating earnout as a component for the purchase price, the 𝗯𝘂𝘆𝗲𝗿 𝘀𝗵𝗼𝘂𝗹𝗱 𝗽𝗲𝗿𝗳𝗼𝗿𝗺 𝗮𝗱𝗲𝗾𝘂𝗮𝘁𝗲 𝗱𝘂𝗲 𝗱𝗶𝗹𝗶𝗴𝗲𝗻𝗰𝗲 to understand the target’s business to 𝗿𝗲𝘀𝘁𝗿𝗶𝗰𝘁 𝗲𝗮𝗿𝗻-𝗼𝘂𝘁 𝗽𝗮𝘆𝗺𝗲𝗻𝘁𝘀/ 𝗽𝗲𝗿𝗶𝗼𝗱 𝘁𝗼 𝗮 𝗺𝗶𝗻𝗶𝗺𝘂𝗺 𝗽𝗲𝗿𝗶𝗼𝗱 (not more than 12 months).
In this way, the 𝗯𝘂𝘆𝗲𝗿 𝗱𝗼𝗲𝘀 𝗻𝗼𝘁 𝗼𝘃𝗲𝗿𝗽𝗮𝘆, and this transition period is enough for the buyer to assume control of the target business and execute synergies.