QUICK OVERVIEW ON EARNOUTS
In many cases, an earn out is used to bridge the gap between the seller and buyer’s valuations. An earnout is a form of financing strategy used in an M&A transactions, whereby a small part of the purchase price is deferred and paid to the seller. Payments seller receive is a percentage relative to the company’s financial performance.
This structure gives the buyer an additional financing option. The buyer may choose to finance part of the acquisition with future earnings.
Key Structural Considerations
- The definition and scope of the target acquisition - (i) line of business, (ii) whether expansion outside line of business falls into earnout structure, and (iii) sales to common customers.
- Agreement on performance – (i) Revenue, (ii) Net income, (iii) EBITDA etc...
- Arrangement on preferred accounting measurement standards – GAAP would be preferred.
- Parameters listed up front in the agreement. Every plausible outcome – good or otherwise – should be included in order to mitigate future drawbacks.
- Early payment triggers are important. There may come a time where the buyer’s growth strategy differs from the seller. The buyer may seek rebranding, operational changes, changes in location, divestiture etc…For such, it is recommended to negotiate early payments.
- Post-merger integration – control, strategies, support, management roles etc...
- Dispute and resolutions – Arbitration or court ruling
There are many ways to structure an earnout strategy. An effective earnout arrangement should be fair for both parties. Given that the buyer and seller will be long-term partners, fairness and flexibility are critical for the long-term success of the company.