When buying a company, a frequent question asked by the acquiring firm when analyzing the business plan of the target company is: will the target achieve these objectives? Most firms use DCF valuation and since it is based on future cash flows, the business plan proposed by the management of the target will have a direct impact on the price offered by the potential buyer. This plan has to be realistic and should not underestimate nor overestimate the target’s capacity to meet its objectives. But what does realistic mean? Obviously a realistic view for the buyer tends to be more pessimistic than the seller’s realistic view. So what happens when both parties can’t agree on a common realistic future of the target company? A frequent tool used to bridge this “realistic future” gap is the so-called “earnout”.
An earnout is a contract which regulates the portion of the total consideration paid by the buyer, which varies on the basis of mutually agreed future events (i.e. performance goals). The total consideration is thus the up-front payment (fix portion paid at the closing) plus the earnout (variable portion paid at a later stage).
The earnout is not limited to the function of bridging the future realistic view of the parties. The tool is also used by the buyer to retain the managers/shareholders of the target company and to motivate them. Since part of the payment will be at a later stage, the managers/shareholders have to stay and/or to perform in order to get paid.
Earnouts are therefore a very useful tool, but has drawbacks too. Earnouts can indeed be complex to define, could cause post-acquisition integration issues, performance goals could be too aggressive and/or managers don’t own a significant earnout claim which in both cases demotivates them.
When structuring an effective earnout, some key elements must be considered. First of all, the earnout amout, which is based on the difference between the fix amount paid up-front and what the seller wants to receive (i.e. the price gap). Generally it varies between 20% and 70% of the total consideration. However, we consider that 30% should be appropriate for both parties. Secondly, the earnout period: the shorter the period, the higher the present value of the expected payments. Thus, seller wants generally a shorter and buyer a longer period. It is important to notice that the period also has an impact on the retention and motivation of managers/shareholders. Third, the performance goals must be clearly defined, mutually understood, attainable and easily measurable. Common criteria include: Revenues, Gross Margin, Pretax Profit, Cash Flow or EBITDA, or Milestones (e.g. new product). Each criterion has advantages and disadvantages. The lower the criterion is on the Income Statement (top being the Revenue and bottom the Net Profit after Tax), the more performing the target must be. A mix of different criteria is also not uncommon. Then, the payment schedule includes two dimensions: the amount of each payment and the timing of those. The amount varies, when the target company meets or fails to meet its performance goals. The amounts are often caped or floored, in order to reduce risks for both parties. The payments can be done in different point in time or as a lump-sum at the end of the earnout period, to reduce volatility.
Once those key elements defined, some issues must be taken into account. The most common are shortly described here. The impact on the potential effectiveness of an earnout might not work if the buyer intends to integrate the operations of the target. In this case, parties should choose performance goals, which allow necessary integration or have a shorter period in order to integrate the target after the earnout period. Then, the Sales and Purchase Agreement (SPA) must also clearly regulate: the accounting rules and performance measurement for the calculation of the earnout; the availability of financing for the target (e.g. if the buyer does not provide the necessary capital, the target needs authority to obtain funds from external sources); how the target’s management will conduct the business (e.g. approval processes); and what happens in case of change of control (i.e. it should not affect the target’s ability to achieve its performance goals). An important point when structuring an earnout is also to submit the earnout proposal to competent tax and accounting advisers!
To value an earnout, the first step is to model different scenarios (e.g. low, high and most likely) of future expected cash flows with key value drivers. Then, simulation can be used to determine the distribution of the present value of those future expected cash flows. The important here is to understand that with the same earnout structure, both parties will have a different estimated value of the earnout. The agreement between both parties will be found, when the total consideration, including the earnout’s present value, will be equal or less than the valuation of the target (e.g. DCF, multiples, etc.) according to the buyer and inversely equal or higher than the value of the target estimated by the seller.
An earnout could be complex to define, but might really help to unlock deadlock situations, if properly structured and then executed.