Earnout

What Is Earnout?

An earnout is a contractual provision in a merger and acquisition (M&A) agreement that stipulates a portion of the purchase price will be paid to the seller in the future, contingent upon the acquired business achieving specific predetermined financial metrics or operational milestones. This mechanism falls under the broader category of corporate finance and is primarily used to bridge a valuation gap between a buyer and a seller, especially when there is uncertainty about the target company's future performance or when the seller believes the business has greater upside potential than the buyer is willing to pay for upfront. Earnouts incentivize sellers to remain engaged and ensure a smooth transition and continued success of the acquired entity.

History and Origin

The adoption of earnouts in mergers and acquisitions has seen fluctuations over time, often increasing during periods of economic uncertainty. These provisions gained more prominence as a tool to mitigate risk for buyers and allow sellers to potentially realize higher total consideration for their business. For instance, the M&A market witnessed a significant rise in the use of earnout deal terms after 2021, with the number of deals including earnout provisions jumping from approximately 20% in 2021 to 33% in 2023. This trend reflects their utility in bridging valuation discrepancies when factors like rising interest rates and inflation create different perspectives on a target business's future performance.¹⁴ Earnouts have been a common feature in M&A deals since at least 2020, with their usage influenced by economic and financial uncertainties, serving to align buyers' and sellers' differing views on value.¹³

Key Takeaways

• An earnout is a post-closing payment in an acquisition, contingent on the acquired company's future performance.
• They are primarily used to bridge valuation gaps between buyers and sellers, mitigating buyer risk while offering potential upside to sellers.
• Common metrics for earnouts include revenue, EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), gross profitability, or non-financial milestones.
• Earnouts can serve as an incentive for key management or founders to remain involved and contribute to the acquired business's success.
• Despite their benefits, earnouts can lead to disputes if not carefully structured and documented, particularly regarding the control of operations during the earnout period.

Formula and Calculation

While there isn't a single universal earnout formula, the calculation is highly specific to each acquisition agreement. The earnout amount is typically determined by applying a pre-negotiated percentage or multiplier to specific performance metrics achieved by the acquired business over a defined period.

A common structure might involve:

Where:

• (\text{Actual Performance Metric}) refers to the company's revenue, EBITDA, net income, or other agreed-upon metric during the earnout period.
• (\text{Threshold Metric}) is the minimum level of performance required to trigger an earnout payment.
• (\text{Multiplier}) is the agreed-upon factor used to calculate the payment based on performance exceeding the threshold.

For example, an earnout might stipulate that the seller receives 10% of any revenue exceeding $5 million in the first year post-acquisition. If the acquired company generates $7 million in revenue, the earnout payment would be (($7,000,000 - $5,000,000) \times 0.10 = $200,000). Parties must clearly define how metrics are calculated, what constitutes the basis for the calculation (e.g., GAAP, non-GAAP), and any adjustments that might apply.

Interpreting the Earnout

Interpreting an earnout involves understanding its potential impact on both the buyer and seller. For a buyer, a properly structured earnout indicates a lower upfront purchase price and allows them to pay for actual, rather than projected, performance. This reduces the risk of overpaying for a business, particularly one with unproven growth trajectories or significant operational dependencies on the seller. From the seller's perspective, a well-negotiated earnout offers the opportunity to receive a higher overall consideration for their business if it performs as anticipated post-acquisition.

The specifics of an earnout provision, such as the chosen financial metrics, the duration of the earnout period, and any operational covenants, are crucial for interpretation. For instance, an earnout tied to EBITDA might give the buyer more control over expenses that impact this metric, whereas one tied to gross revenue might be seen as less susceptible to buyer manipulation. Understanding these nuances helps both parties assess the likelihood of the earnout being achieved and its implications for the ultimate value exchanged.

Hypothetical Example

Consider "TechInnovate," a software startup seeking acquisition, and "GlobalCorp," a large technology conglomerate looking to expand its product offerings. TechInnovate's founders believe their new AI platform will generate significant revenue, but GlobalCorp is cautious due to the platform's nascent stage.

They agree on an acquisition with an earnout provision:

• Upfront Payment: $10 million
• Earnout Period: Two years post-acquisition
• Earnout Metric: Annual Recurring Revenue (ARR) from the new AI platform.
• Earnout Structure: If the AI platform's ARR exceeds $3 million in Year 1, TechInnovate's former shareholders receive an additional 15% of the excess ARR. If it exceeds $5 million in Year 2, they receive an additional 20% of the excess ARR.

Scenario:

• Year 1: The AI platform generates $4 million in ARR.
  • Earnout Payment for Year 1: (($4,000,000 - $3,000,000) \times 0.15 = $150,000)
• Year 2: The AI platform generates $6 million in ARR.
  • Earnout Payment for Year 2: (($6,000,000 - $5,000,000) \times 0.20 = $200,000)

In this hypothetical example, the total additional payment to TechInnovate's former shareholders from the earnout would be $150,000 + $200,000 = $350,000, bringing the total consideration to $10,350,000. This structure allows GlobalCorp to mitigate its initial risk while giving TechInnovate's founders a chance to realize more value based on their platform's performance.

Practical Applications

Earnouts are widely used in private company M&A transactions, particularly where there are differing views on the target company's future value or when the business relies heavily on the seller's ongoing involvement. They are especially prevalent in industries like biotechnology and medical devices, where company value is often tied to milestone achievements such as clinical trial success or regulatory approvals.¹²

• Bridging Valuation Gaps: Earnouts are a common solution when buyers and sellers disagree on the valuation of a business. By making a portion of the payment contingent on future performance, buyers can limit initial exposure, and sellers can achieve a higher potential total price.¹¹
• Risk Allocation: For buyers, earnouts act as a risk allocation mechanism, shifting more of the performance risk to the seller. This is particularly valuable in uncertain economic environments.¹⁰
• Seller Incentive and Retention: Earnouts can motivate key personnel from the acquired company, often including the previous owners, to remain with the business post-acquisition and contribute to its continued growth and success. This aligns the seller's interests with the buyer's objectives.⁹
• Financing Strategy: In some cases, earnouts function as a financing tool for buyers, allowing them to defer a portion of the purchase price until the acquired business generates sufficient cash flow. This can alleviate immediate financial strain on the buyer.⁸
• Specific Industry Applications: In sectors like software, pharmaceuticals, or media, earnouts might be tied to non-financial metrics such as customer retention, successful product launches, or securing new intellectual property rights, reflecting key value drivers in those industries.

Private equity firms have increasingly utilized earnout provisions to finalize deals in challenging economic environments, linking a portion of the company's sale price to its future performance.⁷

Limitations and Criticisms

Despite their advantages, earnouts present several potential drawbacks and complexities that can lead to disputes. They are often referred to as "litigation magnets" due to the high potential for disagreements between parties.⁶

• Operational Control Issues: Buyers typically want full control over the acquired business, but actions taken by the buyer during the earnout period (e.g., changes in strategy, integration decisions, cost cutting) can negatively impact the metrics on which the earnout is based. Sellers may argue that the buyer deliberately suppressed performance to avoid payments. Negotiating restrictive operating covenants can be complex.⁵
• Manipulation of Metrics: The interpretation and calculation of earnout metrics, such as EBITDA or working capital, can be contentious. Sellers might prefer revenue-based metrics, which are generally less susceptible to buyer manipulation than profit-based ones.⁴
• Lack of Payment: A significant concern for sellers is the risk of not receiving the full earnout payment. Reports suggest that only a portion of deals with earnout provisions result in full or partial payment.³ This can lead to significant frustration and legal action.
• Complexity and Cost: Structuring and monitoring earnouts adds complexity to M&A transactions, often requiring detailed legal documentation and ongoing accounting oversight. Disputes can lead to expensive and time-consuming litigation.
• Tax Implications: The tax treatment of earnout payments, particularly whether they are considered additional capital gain for the seller or compensation for services, can be complex and depends on the specific structuring of the deal and tax regulations.² This distinction can significantly impact the seller's net proceeds.

Earnout vs. Contingent Consideration

The terms "earnout" and "contingent consideration" are often used interchangeably in the context of mergers and acquisitions. However, it's more accurate to view contingent consideration as the broader financial category, with an earnout being a specific and common type of contingent consideration.

Contingent consideration refers to any payment in a business combination that depends on future events or conditions. This can include a wide range of scenarios beyond just performance-based payments. For example, it might involve payments tied to regulatory approvals, successful litigation outcomes, or even the continued employment of a key individual.

An earnout, specifically, links future payments directly to the post-acquisition financial or operational performance of the acquired business. While all earnouts are a form of contingent consideration, not all contingent consideration arrangements are earnouts. The key differentiator for an earnout is its direct link to the financial output or operational achievement of the acquired entity.

FAQs

Q: Why do buyers use earnouts?
A: Buyers use earnouts primarily to manage the risk of overpaying for a company, especially when there's uncertainty about its future performance or when the seller has optimistic projections. It allows them to align the final purchase price with the actual value created post-acquisition.

Q: What types of metrics are used in earnouts?
A: Common metrics include financial indicators like revenue, gross profit, and EBITDA. Non-financial metrics can also be used, such as achieving specific product development milestones, securing new customer contracts, or obtaining regulatory approvals, depending on the industry and the nature of the acquired business.

Q: Are earnouts common in public company acquisitions?
A: Earnouts are primarily used in acquisitions of privately held companies. While rare, they can sometimes be incorporated into public company acquisitions. The complexity of public markets and shareholder structures makes them less common for publicly traded entities.¹

Q: What happens if the earnout targets are not met?
A: If the agreed-upon targets are not met, the seller typically forfeits the contingent payment associated with that specific earnout period. This means the buyer pays less than the maximum potential purchase price, and the seller receives a lower total consideration for their business.

Q: Can earnouts lead to disputes?
A: Yes, earnouts are a frequent source of post-closing disputes between buyers and sellers. Disagreements can arise over how performance metrics are calculated, whether the buyer's actions impacted the ability to achieve targets, or if there were breaches of operational covenants. Careful due diligence and clear drafting of the earnout provisions are essential to minimize such conflicts.