Managing Director in the Dispute Advisory & Forensic Services Group Jeffrey J. Mordaunt, CPA, CFF, CLP participated in a discussion on structuring earnouts as part of the Financier Worldwide TalkingPoint.
Financier Worldwide (FW): What trends have you seen regarding the use of earn-outs in the past few years? What is the appetite for using earn-outs in today’s M&A transactions?
Ross: Seller’s interests in earn-outs remains limited since under them the seller bears the risk of future performance. Regardless, their use has been increasing as a result of factors otherwise inhibiting deals, such as the reluctance of buyers to risk cash and, in general, buyers having a greater choice of deals to pick among. This trend does not apply to acquisitions of public companies for which earn outs remain very rare for many reasons, including potential tax consequences. One trend is some increase by private equity firms selling portfolio companies to accept at least a portion of the purchase price via an earn-out.
Amorosi: Given market volatility and buyers’ and sellers’ divergent perspectives on fair market value, it is becoming more common for parties to discuss earn-outs as a means of bridging value gaps in M&A transactions. However, earn-outs are far more often talked about than they are actually used, as they can present meaningful impediments to integration, from a buyer’s perspective, and the risk of manipulation, particularly if tied to any metric other than top-line revenue, from a seller’s perspective. That being said, earn-outs have been used with some frequency in certain industries, such as pharmaceuticals and so-called ‘people businesses’ where the principal assets take the elevator out of the office every day. Particularly in today’s environment, earn-outs need to be in your M&A toolbox.
Mordaunt: Over the past few years, a substantially greater portion of the deals I have been involved with were consummated utilising an earn-out. This is due to a proliferation of factors that have been present the past number of years, including but not limited to national and global economic issues, eager, motivated or desperate sellers, strategic and cautious buyers, and a tightened financial borrowing or funding base. Consequently, earn-outs are necessarily utilised to bridge the valuation gap between the buyer and seller. The appetite for earn-outs remains strong and will be prevalent in transactions for the foreseeable future, as these factors are still in place today and an earn-out is a mechanism the parties can utilise to address these issues.
FW: What are the primary advantages that earn-outs provide?
Amorosi: Earn-outs are principally a means of sharing some pricing risk with the seller which can be particularly useful in early stage companies where operational prospects are not reliably predictable. In addition, they can help bridge value gaps in the sale of traditional later-stage businesses by providing for additional consideration based on the achievement of financial or operating metrics – for instance, gross revenues or net sales over a specified period of time – or the outcome of known contingencies, such as regulatory approval of a new product or the outcome of a particular litigation. They can also serve as a retention tool and a means of preserving the value in a professional services businesses, where the risk of rapid business deterioration in a target business is arguably much higher if key employees are lost shortly after closing.
Mordaunt: Earn-outs provide advantages to both the sellers and buyers in a transaction. From the seller’s viewpoint, an earn-out provides the opportunity to realise their perspective of the value of their business or perhaps an even greater amount. If the owners continue to work in the business during the earn-out period, it may provide them with some level of control over the achievability of the earn-out. The use of an earn-out also increases the ability of the seller to actually consummate a transaction during challenging economic times. From the buyer’s perspective, the earn-out aligns the risk inherent in the transaction: the seller’s optimistic view on value with the buyer’s view on the value received. It also reduces the capital due from the buyer at close, and provides the buyer with some assurance that it received the bargained-for value of the target company.
Ross: First and foremost an earn-out is a means to bridge the gap between the expectations of buyer and seller as to the performance over the next few years of the business being acquired. As part of this, for a seller that thinks it is on an upward trend, it is a way not to be paid only on the historical results. For a buyer it is a way to pay for results rather than expectations. Also, if the seller’s management are significant shareholders, it is a means for buyer to enhance the likelihood of management staying, as management will generally be of the view that they are best suited to maximise the business’ performance. Finally, note that earn-outs generally only make up a portion of the purchase price and the fixed portion can vary from as low as 40 percent to as high as 90 percent.
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