Earn-Outs: What Are They, Why Do Buyers Use Them, and How Could They Impact Your M&A Transaction?

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Insights

January 18, 2021

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:

  • They keep the seller active and focused on the growth of the company post-closing.
  • Earn-outs are often used to bridge valuation gaps between buyers and sellers: buyers can pay a higher valuation when the forecast targets are achieved and sellers are provided with the ability to achieve the value they are seeking.
  • They provide buyers with a form of acquisition financing by reducing the cash paid at closing.
  • In the case of significant customer concentration (i.e., a high % of revenue is tied to three or four accounts), earn-outs tied to retention of these key customers reduce the risk to the buyer and more accurately reflect the value of the company should one or more of these clients leave within a year or two of closing.
  • Earn-outs can be tied to the retention of key employees as well; this is especially true for professional IT services organizations

Advantages of earn-outs for sellers include:

  • They provide sellers that have strong deal pipelines with the ability to claw back a percentage of the future revenue they are confident in achieving (and have invested resources to build).
  • Just as for buyers, earn-outs can be used to bridge the valuation gap between the valuation that a seller is seeking and the valuation that a buyer has determined the acquisition is worth to their organization.
  • Earn-outs can sometimes be the additional valuation needed to make the offer more compelling than offers from competitive buyers; because earn-outs are structured on achieving some positive milestone (usually revenue), they offer an advantage to both sellers and buyers in this situation.

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-Out Milestones

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)

Earn-Out Formula

The earn-out formula describes how payments are to be calculated once the earn-out milestones are reached.

Earn-out formulas often include:

  • The percentage of the milestone that is to be paid to the seller and its timing
  • The cumulative dollar limit over the term of the earn-out
  • The earn-out period
  • How below-target and above-target milestones will be handled

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.

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