From 2020 to 2022, EBITDA became almost as prevalent as revenue metrics for determining earnout payments, according to analysis of the Goodwin Private Equity Deals Database. In 2022, EBITDA was used in 40% of earnouts, up 22% from 2020. Revenue metrics were used 48% of the time, down 23% from 2020. This convergence marks a significant shift in the market.
Choice of metrics reflect deal and market dynamics
Earnouts allow dealmakers to make a portion of the value of a transaction contingent on future performance. They are often used to get a deal done when the buyer and seller disagree about valuation, particularly in times of uncertainty. The types of performance metrics dealmakers agree to use to calculate earnout payments can be revealing.
Buyers tend to favor EBITDA because it puts the emphasis on profit and operating performance rather than top-line growth. This makes it a good measure of financial health, revealing the company's ability to service debt and fund future growth.
Sellers tend to favor revenue metrics because they are easy to monitor and calculate. They may also consider revenue metrics less risky because they are less affected by increases in cost and expenses, which may be more susceptible to manipulation by buyers when the seller is no longer in control of the company.
Of course, dealmakers can use more than one performance metric in their earnout agreements, and EBITDA and revenue metrics are not the only metrics dealmakers use. In fact, other metrics that were not pegged to EBITDA or revenues (such as gross profit or customer retention) were used 21% of the time in 2022.
Optimizing for success
When considering EBITDA, dealmakers should keep some basic guidelines in mind to ensure the terms of their earnouts encourage the desired outcomes.
- Clearly define EBITDA in the earnout agreement. To that end, consider including an illustrative calculation as an exhibit.
- Consider incorporating additional deal incentives for the seller, such as incentive equity, with different performance metrics. This can help balance short-term and long-term goals.
- Be sure that EBITDA is the right choice for the target industry and can serve as an accurate measure the target company’s performance. Getting these factors right can significantly affect the success of the deal and the satisfaction of the buyer and the seller.