Introduction to Earnout
Earnout can be defined as a contractual arrangement of pricing in mergers and acquisitions where the seller of business earns compensation in future after the business achieves its financial goals and objectives following the acquisition usually expressed in the form of certain percentages, say on gross margin or on net profit after tax etc.
Explanation
An earnout is a contractual mechanism done between the business seller and the buyer where the buyer of the business agrees to pay in future based on earnings usually undertaken when there is disagreement on growth and performance aspects of the target company. This generally takes place over a period of three to five years involving ten to fifteen percent of the purchase price being assessed over that period after closing of the acquisition. The terms and conditions of an earnout are dependent on the party that manages the business after closing. An earnout arrangement does not have a hard and fast set of rules to be followed. It is used to bridge the valuation gap from the buyers and sellers.
Example of Earnout
ABC company is running a business of FMCG in which during the last financial year sales were $300 million and earnings were $100 million. Mr. John wants to buy the business of ABC Company Ltd. at a price of $150 million. The owner of ABC Ltd. is ready to sell his business but he believes that the price offered is very low and would also undervalue future growth prospects of the business.
So the owner asked for $300 million price for the business which Mr. John denied. Parties decide to use an earnout method to come to a solution and bridge the gap of the difference amount. Owner of ABC Ltd. asked from Mr. John to make the upfront payment of $150 million and earnout payment of $150 million to be paid in case if the earnings reach the level of $200 million with the period of three years window or else $50 million will be given as the earnout money to the ABC ltd if the sales reach the level of $100 million. If these targets are not met, then the seller will not be paid anything in the future.
Earnout Structuring
There is no single simple earnout method for the entrepreneur looking for a quick sale of their business. Significant risks are involved in any acquisition that comprises future conditions. Earnout depends on a various matrix of variables and goals like determining the crucial members of the organizations, cash compensation, length of the contract revenue, net income, EBITDA target, etc. Accounting assumptions need to be considered.
Sellers prefer revenue which could be boosted through business activities while buyers tend to prefer net income as the most appropriate point of reflection for the economic performance of the company. Margin level sales, gross profit, operating income, environmental cost, etc. are considered in structuring earnout.
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Earnout in M&A Transaction
To achieve a successful merger and acquisition transaction, the following two key points need to be considered:
- Deal Structure
- Valuation
In the deal structure, earnout allows a specified percentage on which sales price are agreed upon. The percentage of the sales price is generally related to the performance of the targeted business. If the financial matrix is met, sellers of business will earn more money. In deal structure, partial purchase consideration is paid by the buyer to the seller at a specific date in the future once the performing goals are achieved. Here the buyer and seller share the potential risk of future growth which does not get accounted for by using a simple EBITDA method. This process allows the buyer to reduce the risk. It helps buyers and sellers to close the deal. Earnout provides an addon option to finance an acquisition and lessen the upfront cost. For the seller, it provides the option of obtaining a higher selling price, capturing the value of an ongoing business. It also involves risk as it is dependent on the future success of the business. Care should be taken while drafting an agreement for earnout in merger and acquisition. Another part is the valuation. Higher the valuation of the business, the more is earnout payment, the potential buyer needs to make.
Benefits of Earnout
Earnout mechanism is advantageous for both buyer and seller:
From the Sellers Prescriptive
- Even after selling the business the seller can contribute and participate in the growth of the target company.
- The seller gets the full benefit of selling a business and will not have to discount the purchase price even if the buyer has a doubt in the target company.
- Even after selling the business, the seller earns a fixed income once the desired targets are achieved.
From the Buyers Prescriptive
- The buyer has to pay the earnout money only if the business turns to be profitable and achieves the desired target.
- Earnout provides protection against overpaying and uncertainty.
- The amount of the purchase price has the cash flow benefits and the buyer is not relied on being granted a loan.
- Sellers will be motivated to stay in the company thus helping in client retention and transition for the buyer.
Limitations of Earnout
Some of the limitations are given below:
- It creates a potential threat for future disputes as and when the target company does not earn the profit both for the buyer and seller. Here the seller will feel short of the profit and the buyer will feel that he got involved in the wrong deal.
- Sellers involvement will be retained in the company even after he has sold the business which would potentially create friction between both the parties.
- The buyer would want to pull out the seller in different directions and the seller would want to maximize his profit during the earnout period.
Conclusion
If properly exercised and understood earnout proves to be an elegant solution to eliminate the valuation gap between buyer and seller. Both parties should be aware of the weakness and strengths of the earnout. A properly crafted and drafted earnout agreement has a higher possibility of earning for both parties The team involved in earnout agreement including investment bankers should structure earnout well and the transaction attorney needs to ensure proper documentation. If done in the right way, earnout turns to be fruitful for every party involved in the deal.
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