What is an Earn-Out?
An earn-out is that portion of the purchase price for an acquired business that is contingent on the seller achieving certain milestones and / or retention of key customers and / or key employees during a specified period (typically 1-3 years) after closing. The contingent purchase price is “earned” when the seller achieves the milestone.
Earn-outs are more frequently used in IT Service company transactions because so much of the value resides in the team and the customers, unlike software companies where, although the team and clients still hold tremendous value, there are tangible IP assets and recurring revenues under agreement.
However, the past year has impacted many companies and we are frequently seeing companies whose 2020 results aren't indicative of historical or projected growth and profitability. As a result, we're seeing an increase in the use of earn-outs in M&A transactions.
Advantages of earn-outs for buyers include:
Advantages of earn-outs for sellers include:
Important to Note:
Sellers need assurance they can continue to run the business without undue interference or additional cost burdens that can hamper their targets.
The buyer needs to be able to capture the performance of the seller’s business post-closing so that the numbers accurately reflect performance.
Earn-outs are most often based on the seller reaching post-closing financial milestones typically tied to Revenues or EBITDA. It is generally more advantageous to structure an earn-out tied to revenue. Revenue is easier to track and sellers have more control over revenue. Earn-outs based on EBITDA are generally ill-advised because EBITDA is a more easily manipulated number (for example, the buyer could burden the acquired firm with additional costs thus decreasing the EBITDA).
Earn-out milestones can also be non-financial and can include retention of key staff or clients over some period of time (often 1-3 years post-closing)
The earn-out formula describes how payments are to be calculated once the earn-out milestones are reached.
Earn-out formulas often include:
These are just a few of the many concerns and issues around structuring earn-outs as part of an M&A transaction. It's important to work with an experienced advisory firm who can optimize the structure of an earn-out during negotiations with the buyer to help to ensure it is realistic and structured so that you are able to achieve it without any hidden claw-backs, penalties, or undue restrictions.
If you are interested in learning more about the critical items to consider when an earn-out is part of an M&A transaction structure, let's have a call.