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This blog covers earnouts in M&A deals.
Earnouts are becoming more and more common in M&A deals. While before relatively rarely used in non-life sciences deals, earnouts appear in around 25% to 50% of M&A deals today. Earnouts are more common when the individual seller is tied to the success of the business. Earnouts in effect double as the bonus compensation given to individual sellers in their employment agreement with the new company. However, earnouts seem to be becoming a smaller percent of aggregate consideration. A few years ago, some deals had 33% of the purchase price tied to a successful earnout. Today, it seems like it is closer to less than 20%. The percentage does increase if the individual seller is tied to the success of the business.
The most common metric is revenue followed by EBITDA. Sometimes, specific items trigger a realization on an earnout. If so, the amount of the escrow could be higher. Depending on the metric, earnout can be very short or up to three years.
There are several things a seller should consider when negotiating an earnout.
1) The realization of an earnout is often out of the seller's control. It is tied to how the buyer runs the business post-closing. That is frustrating to the seller. Sellers can negotiate to make the buyer obligated to run the business to maximize the earnout payments. This clause can be worded to mandate the buyer to devote sufficient resources to maximize the earnout, such as new hires and incentivizing current employees to sell the target business. If EBITDA is the target, sellers need to be aware of the new business' expenses and their effect on profit.
2) Does the earnout accelerate upon a change of control? This is often a tricky issue in negotiation. Buyers hate the provision because it causes them money when they turn around and sell the new business. However, there is a logic to it from the seller's point of view. A sale of the new business is generally associated with the success of the new business. Why shouldn't the seller share in such success?
3) Can the buyer offset indemnity claims against future earnout payments? This provision is fairly common, even though more sellers are successfully resisting it. The compromise is that the earnout payments are tolled if there is a dispute. This has the effect of increasing the size of the indemnity escrow.
4) Cash is still king. Earnouts are always risky, even if the targets seem easy to reach. Forecasts cannot be met for a multiple of reasons. Taking a lower aggerate purchase price may be worth it if the cash at closing is greater.
5) The time period for an earnout has to be the same length or shorter than the individual seller's employment agreement with the new business. The seller needs some input on whether the new business can achieve the targets in order to be able to maximize the earnout.
If you are negotiating an earnout in the sale or purchase of a company, please contact Rob Marks of Tomlinson Advisory Group at email@example.com.