When Did The Earnout Really Workout?
Many private transactions include a final payment component that is based on the future performance of the business, an earnout. It is a contingent payment from the buyers to the seller shareholders that is earned if certain milestones are reached. An earnout is generally viewed as an equitable mechanism to bridge the gap in valuation expectations between the buyer and the seller and as a way to maximize value for both sides.
For the seller, the greater the cash payment on closing, the better. However, the earnout is attractive payment component in that it provides a chance to generate additional value from the sale process. Without question, an earnout clause requires a leap of faith that both parties will stick to the rules; however if the earnout targets are reasonable, the mechanisms are in place to enable seller to verify the company performance and there are mechanisms to limit any manipulation of the performance, then the earnout can be an enticing opportunity to significantly increase the proceeds for sellers.
Buyer’s too benefit from the properly established earnout clause. The additional payment is a method to retain and motivate management to continue to run and grow the company. It is also a way to ensure that the purchase price paid is based on real performance and not on the seller’s projections.
What metrics are used to establish the future earnout targets? The most common ones in private transactions tend to be financial goals as they are the simplest to track and report on. These include specific thresholds for:
- Earnings before interest, taxes, depreciation and amortization (EBITDA)
- Gross margin
- Net revenues or revenues
- # of clients or new clients
Non-financial metrics are also a possibility but less frequently applied. These are elements like a launch of a new product, expansion into a new territory, retention of key employees.
To be effective, earnouts generally require reasonable period of time to effectuate the goals (generally this ranges between twelve months to three years). The payment schedule for the earnout should closely match the goal achievement, allowing reasonable delay for the supporting financial documentation. In some cases, the goal may be annualized; in other situation a cumulative target over the entire time frame makes more sense.
Earnouts are very a customized aspect of any transaction and having experienced M&A lawyers are a key part of any successful earnout. They will leverage several key covenants and provisions to increase the trust around an earnout and protect both sides. In parallel with the legal ease, when asked, these are the critical factors of success advisors and lawyers most sited as key to a winning earnout:
- Clearly discussing the possible performance outcomes, the roles & responsibilities of both parties pre-closing;
- Alignment of intensions – although you can’t plan for everything you will be more likely to success by working together;
- Setting clear objectives are measurable, timely and attainable;
- Devising a simple earnout formula that can be easily be referenced post-transaction so that the executing team know what they are looking to achieve;
- Carving out any exceptional circumstances such as expenses that would not apply to the earnout target, a change of control in the business, a material change in operations, any exceptional expenses and/or early achievement of goals;
- Ensuring that those executing the are empowering to deliver the results;
- Committing to periodic financial reporting and information sharing;
- Having strong due diligence to ensure the buyer knows the business;
- Clearly defined dispute mechanisms
Earnouts can be complicated or as simple as you make them. They are intended to be a winning formula for both sides, so keep that in mind as you determine how to leverage an earnout within the context of your next transaction.