Earn-Outs: Hero or Villain?
At some point in deal transactions, a buyer may propose an offer that includes an ‘earn-out’ element of the price. Perhaps surprisingly, an earn-out is usually viewed by sellers with much suspicion.
But what is an earn-out? And should an earn-out be viewed as “Hero’ or ‘Villain?’
An earn-out is simply a part of the price, or ‘consideration’, that is paid after the deal completes, and is contingent on some element of the business performance. An earn-out can be based on a number of metrics – it could be profit (e.g., EBITDA), or it could be revenue based, gross margin based, or indeed any other metric that may be relevant.
An earn-out is usually offered to bridge the value that a seller wishes to achieve, and the price a buyer is willing to pay. In a sense, sellers (perhaps unwittingly) often create the earn-out scenario, simply by setting a high minimum price from the get-go. But of course, competitive tension between multiple bidders is also a factor – the ‘market’ price of an attractive acquisition may be so high that a buyer has to engage the ‘earn out’ mechanism to achieve the price required by ‘the market.’
As well as bridging economic value, the earn-out is becoming more popular, simply because of the uncertain economic backdrop. Buyers have had to contend with various ‘headwinds’ over recent years – Brexit, the pandemic, rampant inflation and now war on European soil.
These headwinds mean that predicting company performance is now particularly difficult for both seller and buyer. The earn-out provides a mechanism for mitigating risk that a buyer does not overpay for an acquisition should trading conditions deteriorate significantly.
So, no surprise that around 50% of the deals we currently see contain an earn-out element….
What are the typical earn-out scenarios? And do they pay out?
An earn-out is, first and foremost a negotiation. There is no specific rule book as to the split one may achieve between the value paid at deal completion (X%), versus the amount paid by earn-out (Y%). As a general rule of thumb, we tend to focus on capping earn-outs at a maximum 20% of the overall consideration, and ideally paid within 12 months of the deal completing. It all depends on the overall quantum on offer, the associated value (e.g., EBITDA multiple) and the goals of seller and buyer.
For example, not all sellers wish to retire – in fact, a large buyer can often provide new opportunity in terms of career evolution for a seller. This ultimately becomes a material element of any price / deal negotiation. An earn-out can provide the mechanism to make more money from a deal, not less.
[Whilst capping earn-outs is a focus, there are exceptions to the rule. For example, many years ago we had one client who was offered £1M for his business. We achieved, through a lot of negotiation, a final price of just under £14M, 60% of which was to be paid through earn-out over three years.
Did he receive the full value? In short, yes. The company in question was a high growth technology business – the owner was extremely confident that the business would achieve the forecast and was happy to stick around and deliver the numbers.
So, in this scenario, whilst the earn-out on paper looked precarious, the reality was different. The overall valuation as an EBITDA multiple was, frankly, staggering – and could only realistically be achieved using an earn-out mechanism].
Acting for ‘sell-side’ clients, our primary goal is to do our very best to achieve a workable earn-out – one that satisfies the buyer, but most importantly, one that is achievable by seller.
Do they generally pay out?
In our experience, yes. There does of course have to be economic mechanisms that limit the ability of buyer to adversely affect the acquisition post-deal – but in our experience, a corporate buyer understands this. The key to negotiating the earn-out is to ensure that it is reasonably achievable and that the mechanisms for calculating the results are straightforward and transparent.
In fact, the only time we have seen earn-outs fall short is where sellers have negotiated it themselves. Negotiating an earn-out needs to be based on solid financial modelling – and often as not, left alone, sellers can over-cook the numbers with a less than rigorous approach…
[There is one variable that is important here – and that is the ‘quality of the buyer’. Not all buyers are borne equal – we operate solely in the enterprise space, dealing mostly with financially secure large corporate buyers who are generally highly experienced and well capitalised. Smaller buyers, for example those who lean heavily on debt-financing, can be aggressively focused on maximising ‘buy-side’ value – simply put, be careful if you find yourself dealing here…].
So, should sellers view earn-outs with suspicion?
Ultimately, it all comes down to expectation on price. Fewer companies in the SME / enterprise space command market premiums that can be leveraged as 100% cash-consideration with a ‘frothy’ price attached.
The simple fact is that earn-outs are increasingly part of the M&A landscape right now – so a seller should get comfortable that this may be part of any deal offered, at least until economic conditions become more stable.
But with an experienced M&A guide, an earn-out should generally not be viewed with suspicion. Let’s say, somewhere neutral between ‘hero’ and ‘villain.’
And on a final (light) note. Many sellers take informed advice from ‘their mate in the pub who sold his / her business and never received a penny of the earn-out.’ Pubs are for drinking in, keep that in mind when accepting free advice!
To discuss your business exit, please contact us here.
Tags: business exit, earn-out, EBITDA, Financial modelling, M&A guide, M&A landscape, mechanism, negotiation, risk