The purchase and sale of businesses is, by nature, lengthy and extremely complex processes. Whether it’s a founder who seeks to raise capital via a part-divestiture or as part of a growth-via acquisition strategy, an M&A can be divided into two main components, which are; risk management and valuation.
In the world of M&A’s, it is not unheard of for a strategically accretive transition to fail to consummate due to either the buyer’s inability to mitigate risk or a difference in the ascribed valuation of the business.
Whenever businesses (including their assets) are sold, the buyer is going to need to structure and finance the purchase price.
More often than not, a full price is paid on completion.
However, it is not unheard of for the buyer who either cannot afford to pay the full amount, in the chance to make a defined deferred payment, or they may think that there’s just too much risk.
In either circumstance, an “earnout” is the arrangement in which the price which the buyer has to pay is based on the performance of the business after the completion of the acquisition.
Oftentimes, there’s a payment during completion, which will reflect the value of the net assets of said company.
This is then followed up by a single or multiple payments that are all based on how the business is able to perform over a subsequent reference period.
Advantages For The Buyer
One of the benefits of an earnout is that they are most useful in instances where it is difficult to valuate a business or when a business is entirely new and does not have a past track record to gauge its profitability.
In the case of the buyer, an earnout is advantageous mainly because if the performance of a company does not meet the initial thresholds or targets that were set, then any and all further payments to the seller is going to be reduced accordingly and could also be eliminated depending on the specific situation.
When it comes to an earnout, the buyer is also allowed to hedge their risk on the acquisition, which is considered to be a crucial step of the financing.
Advantages For The Seller
On the flip side, the seller has to deal with an increased risk in a transaction mainly because, in most cases, the main portion of the purchase price is deferred until after accounts have been drawn up to assess the company’s performance.
For the seller, this could mean having to wait for a year or more after they have sold the business to get paid the full asking price.
Additionally, the seller is not guaranteed that they are going to get security for the deferred payments while relinquishing much of its control.
It is possible for a seller to negotiate a lucrative deal with an earnout, which means that both the buyer and seller benefit from the good performance of the company during the reference period.
By sharing the risk on future performance, the potential upside is considered to be greater than what the buyer would have been prepared for to pay if the deal involved having to pay a fixed price.
While some earnout targets and structures are simple, others can be complex and could ultimately prove to be quite difficult to monitor.
This is mainly the case when both the buyer and the seller are aiming to reduce the amount of risk involved in the transaction while at the same time increasing the chances of profits to their side of the negotiation.
This is why making both parties concerned about an earnout value and determining performance targets can oftentimes be a lengthy process.
While the acquiring company might want to tie the final sale value to a future profit result, doing so is not always easy since many factors need to be considered.
For instance, if a company that operates in one city buys another company in the same sector but a different sector, measuring the profitability is going to be a relatively easy process.
However, if a company is in the same city and also has overlapping customers and offers the same services as the acquiring company, then it the two will basically be competing for customers, making it far more difficult to measure the profits of the acquired company.
The Earnout Contract
The contract of the earnout is going to include all provisions that are relevant to the preparation of the accounts in order to assess the financial performance of a company and determine the price payable.
This will also include any provisions for the settlement of disputes that are related to those accounts and protection for the seller for dealing with how the company is going to be managed once the process of completion is through.
This will also include imposing constraints on the buyer as well as how the business is going to be run.
What Do Buyers Look For In An Earnout?
For any buyer who spends a substantial amount of money for purchasing another business, there are quite a few reasons why they would want to make the process of integrating the company as streamlined as possible.
The following are just some of the reasons what buyers look for in an earnout.
- Part of the purchase price is going to be deferred for a period after completion. For the buyer, this is going to be extremely beneficial from the perspective of cash flow.
- The earnout is going to ensure that at least part of the purchase price will be linked to the actual performance of the business after completion. This is great since it helps remove any uncertainties from the transaction process.
- In some cases where the majority of sellers are key to the target business, the retention of their loyalty in a scenario where almost all of the sellers are key to the target business, an earnout offers retention of their loyalty.
- And lastly, buyers prefer earnouts in order to achieve cost savings along with a greater combined sales and marketing effort. This is only possible if the integration process is started sooner rather than later to start to gain returns on their investments.
However, there are some instances where an earnout may not be as beneficial for a buyer, such as, in instances where the vendor puts the profit target at the top of their priorities list, which results to them becoming extremely focused on just the short-term profitability of the company, but at the expense of long-term profits.
As a result, this approach could leave the buyer with a company that’s in a lowered state than at the time of the transaction.
Additionally, if one of the vendors decides to leave the business before the end of the earnout period, the buyer could be reticent to make the payments of the earnout.
What Do Sellers Look For In An Earnout?
There are also quite a few advantages for the company selling itself. The following are some of those benefits:
- The earnout can offer a mechanism where the seller is able to reap the benefits of selling. For instance, without the earnout option, the buyer’s price may be discounted as a result of doubt about the actual profitability of the target.
- Being a part of a bigger buyer’s group opens up more possibilities for the seller.
- Also, the earnout period itself enables the vendor to remain focused on short-term profitability instead of focusing on the longer-term opportunities for the time being to achieve the profit target.
But, an earnout can be just as tricky for the seller as it is for the buyer. Here are some quick reasons why earnouts aren’t always a good idea from the seller’s perspective.
- The fluctuations in profitability that occur after the completion period can often make it more difficult for sellers since they are usually in no position to take the brunt of such price fluctuations.
- In another scenario, the seller could also be cautious of an earnout if there is a threat of it being either reduced or if it is not payable in those instances, then they could be deliberately forced out by the acquirer in order to avoid payments.
As you can see, while earnout provides both sellers and buyers with a fair share of pros and cons, this does not mean that there is no place for earnouts when it comes to mergers and acquisitions.
That being said, it is crucial for both parties who are involved in the transaction to properly think through the potential consequences of going through the deal structure and whether it will provide them with the outcome that they want from the transaction.
Lastly – if you want to prepare your business for M&A and increase its perceived value, contact us and let’s have a quick chat.