Earn-Outs – contractual formulas in M&A transactions generally used to give sellers the opportunity to earn additional purchase price – are often derided for their ability to disappoint sellers, or worse, create post-closing disputes. But Earn-Outs can serve a very useful purpose in the right situations; typically, the acquired business must be allowed to continue to operate somewhat independently for an Earn-Out to make sense. Earn-Outs generally allow parties to put a deal together that might not otherwise be possible. They can do so by bridging a gap between the parties’ views of the target company’s value. Most helpful when the target company has experienced rapid growth during the period just prior to the time of sale, an Earn-Out provision allows the seller the opportunity to prove that its pre-sale growth curve will continue post-closing and can give the buyer the assurance that additional purchase price will only be paid if the future growth projected by the seller actually materializes.
The need for the possible use of an Earn-Out mechanism is created because sellers whose business has been growing want to value their business on the basis of projected future cash flows, generally measured by EBITDA; after all, future cash flows are what the buyer is really acquiring. Buyers on the other hand, generally want to value a business on the basis of past EBITDA; after all, that’s the only thing that has been proven. When EBITDA has been relatively stable this gap is generally not that big. However, when a company has had rapid growth, a valuation based on historic EBITDA can vary widely from a valuation based onprojected post-closing cash flows. In such situations, an Earn-Out, properly constructed, can bridge the gap.
If an M&A transaction is such a candidate for an Earn-Out, structuring it in a way to make it successful is imperative. “Successful” in this context means that the buyer and seller agree on what measurable metric of post-closing performance of the seller’s business satisfies the criteria that will result in the payment of additional purchase price. This is where the “devil in the details” comes in.
Generally speaking, Earn-Outs based on post-closing profits, or even EBITDA, are unreliable. That is because an Earn-Out formula using profits or EBITDA is generally constructed based on historic operations. But buyers generally don’t leave purchased businesses completely as they were. Rightfully so, they integrate, apply buyer reporting and measurement systems, and adopt changes they perceive will enhance the target’s operations or achieve synergies with buyer’s own business. Allocations of the buyer’s overhead to the seller’s cost structure can also alter the target company’s projected financial results. In addition, using earnings or EBITDA as the measure for an Earn-Out provision is more likely subject to manipulation. Accordingly, comparing the pre-closing financial performance of a target to its post-closing performance is often like comparing apples to oranges. This is where disappointments and disputes breed.
More successful Earn-Outs are those with simple, straightforward metrics that are not easily manipulated. These metrics include revenues generated, or if easily defined and tracked, gross margin. While using these measures may not yield results as precise as the buyer’s valuation model (which most likely utilized a discounted cash flow analysis), they will be indicative enough to prove that the seller’s growth projections were accurate.
If an Earn-Out can yield positive results for both parties – a higher purchase price for the seller and a higher financial performance for the buyer than historic results – the results are “win-win.” So, although Earn-Outs are not appropriate for every transaction, do not avoid them altogether – just pay attention to the details.