How to Structure Effective Earnouts
An “earnout” is an acquisition payment mechanism where a portion of the purchase price of the selling company will only be paid by the Acquirer if the Seller attains agreed-upon performance goals after the closing.
Well-structured earnouts allow growing companies to increase their sales price and incentivize the Seller’s management team to stay with the Acquirer after the closing of a transaction. By contrast, poorly structured earnouts reduce the Seller’s value to the Acquirer, demotivate management, and result in litigation.
II. Why Use An Earnout?
There are two reasons why earnouts are used:
Pricing Bridge: The most common reason for using an earnout is to bridge the valuation gap between the Acquirer and Seller’s valuation. When both parties agree that the valuation would be higher if the Seller met future performance goals, they can make the differential between their valuations subject to an earnout.
Incentivization of Shareholder/Managers: Another reason for using an earnout is to incentivize key managers, who are also shareholders, to remain with the Acquirer after the sale and continue to grow the combined entity. If a portion of the purchase price is subject to growth performance goals after the closing, the Seller’s shareholder/managers have an incentive to remain with the company in order to participate in future payments.
III. What Are The Potential Problems With Earnouts?
When problems occur using earnouts, they generally fall into the following categories:
A. Integration of the Seller into the Acquirer
The more Seller’s operations are integrated into the Acquirer, the less control Seller’s management will have over achieving performance goals. In an integrated company, revenue, expense and profit decisions may be made to benefit the combined entity instead of the Seller. To avoid this problem, choose performance goals that will not be adversely affected by integration during the earnout period.
B. Complexity of Definition
It is difficult to create effective earnout formulas. While the earnout concept may be simple, objective numerical definitions can easily become complex. To avoid this problem, choose simple performance goals that are unambiguous, simple to track and easy to measure.
C. Overly Aggressive Performance Goals
In order to get the highest valuation, management may be tempted to base the earnout on overly aggressive performance goals. It should be remembered that growing companies rarely can predict their future performance with any accuracy. To avoid this problem and to minimize management demotivation, performance goals should be realistic.
IV. Structuring an Effective Earnout
The following are key elements to consider when structuring an effective earnout:
A. Earnout Amount
What is an appropriate balance between the payments at closing and the amount of the earnout? The answer depends on the strength of the Seller’s position and the total risk in the earnout. There is little point to a small earnout if the earnout ratio is less than 20% of total consideration. In this case, it is preferable for the parties to continue negotiations until they agree on a price. In contrast, if the earnout ratio is more than 40%, the Seller may be assuming too much risk in the transaction. Our experience shows that most earnouts range from 20-40% of the total purchase price.
B. Earnout Period
Earnouts typically run for a period of one to three years. Like the earnout amount, the earnout period is usually determined by the negotiation price gap. As a rule of thumb, the larger the earnout amount, the longer the earnout period. From the Seller’s perspective, the longer the earnout period, the greater the risk that it will not attain the performance goals. As a consequence, the Seller should try to keep the earnout period as short as possible, therefore reducing risk.
C. Performance Criteria
Earnout payments can be based on any number of measurable performance criteria. To be effective, performance criteria must be specific, measurable, achievable and relevant to the shared vision. The following performance criteria should be considered:
Revenue: Many earnouts are based on the revenue earned on the Seller’s product line or business. Revenue-based earnouts have the advantage of allowing the Seller to be integrated into the Acquirer business without interfering with the earnout.
Cash Flow: In some cases, the Acquirer may want to base the earnout on the Seller’s cash flow. Cash flow may be the suggested if Acquirer wants to impose discipline on a Seller that has historically been a large cash consumer.
Milestones: Payment also can be contingent on the Seller attaining non-financial milestones, such as completion of some specified critical product development, product shipment, or contract execution. If the Seller meets those milestones, specific event-based payments can be made.
Guaranteed Payments: Earnouts may contain guaranteed minimum payments, based either on the passage of time or on the absence of a negative event. For example, in a simple presence condition, payment may be earned if the Seller’s senior management remains with the Acquirer for one year.
D. Performance Goals
Performance Below Goal: In most cases, the Seller should receive some partial payment if it attains at least 50% of the performance goal and the payment amount should increase linearly thereafter up to the performance goal.
Performance Above Goal: Some formulas pay premiums if a Seller exceeds its performance goals. Other formulas may cumulate any excess and allow the Seller to apply it to offset any periods in which it fails to meet its goals.
Cap on Payments: Acquirers almost always cap the payments that can be earned in an earnout. If the Acquirer caps the total payments that can be earned, the Seller should seek minimum annual payments and the right to premium payments if it exceeds its performance goals.
V. Acquisition Structure
Use of an earnout does not preclude flexibility in structuring acquisitions. Earnouts can be included in tax-free and taxable transactions and in mergers, stock-for-stock acquisitions, or asset acquisitions. The earnout can be paid in stock or in cash.
VI. Shared Vision
Earnout performance goals should be founded on a shared vision for the Seller’s ongoing operations within the Acquirer. The success of an earnout depends on the shared vision of key managers. Both sides must believe that they will be truly better off if the earnout succeeds.