Posted by Kris Tabetando | January 13, 2015
WHAT IS AN EARNOUT?
In technology mergers or acquisitions, an earnout refers to a deal structure in which the buyer pays part of the purchase price of the tech company post-closing if the seller achieves certain goals. These goals may be financial or operational targets.
As the name earnout indicates, the seller must “earn” a portion of the purchase price by successfully achieving these targets.
The most common targets used in earnouts are financial targets which include gross revenues, net income, or EBITDA.
Operational targets are sometimes used, say, when a buyer is acquiring a development stage business. These businesses are not yet established and generally do not have significant revenues.
The buyer may be acquiring the business for the products in its development pipeline. The deal makes sense only if the business can successfully develop and bring these products to market. Therefore, a buyer may set these objectives as targets that the seller must meet before earning an additional portion of the purchase price.
WHY EARNOUTS ARE POPULAR WITH TECHNOLOGY COMPANIES
1. Retain & Motivate Key Personnel
Tech companies usually have founders or managers who are very important to the future success of the business. These individuals may have developed the products that the business sells to its customers. Often, the staff are very loyal to the founders who hired them and helped them grow their careers. As such, the buyer may need to retain this key personnel to continue to run the business post-acquisition.
If a seller receives a big cheque that covers the full purchase price of the business, then he has no incentive to work hard in the business after selling it. He must be offered some significant incentives to encourage him to continue to operate the business at its optimal level. This is where an earnout may be an appropriate solution.
The buyer can structure an earnout that motivates the seller to hit certain growth targets and receive more financial compensation over time. This aligns the interests of the buyer with the seller.
2. Unpredictable Growth Trends
Tech companies often grow in an unpredictable and exponential fashion. They can burn through cash fast, and grow or die just as quickly. It is virtually impossible for anyone to accurately forecast the growth trajectory of a tech business.
Nobody knows where the business will be in the next 5 years. The financial projections and valuations performed prior to the acquisition are always educated guesses. The truth is they’re usually wrong.
Every business seller I’ve ever talked to believes that his business is on the verge of a breakout in revenues. And every buyer I’ve ever talked to doesn’t believe it.
The seller’s high valuation expectations are a result of these ambitious growth projections. The buyer is significantly more conservative and has much lower valuation expectations.
This creates a valuation gap between the buyer and seller.
An earnout can be employed when the buyer and seller disagree about the expected growth and future performance of the company. If the business does as well as the seller expects it will do, then he can participate in the upside. It’s up to the seller to prove to the buyer that the business can, in fact, achieve these projections.
3. Reduce Buyer Risk
Technology deals in hot sectors can be very expensive. However, technology trends change constantly. What’s hot today will not be hot tomorrow. A trend can quickly become a fad. This presents a unique risk to technology business buyers.
A buyer could use an earnout to reduce his risk when acquiring businesses in these hot niches that command high valuation premiums. Instead of shelling out a large amount of cash upfront for the technology business, the buyer can pay a portion of the purchase price today, and only pay more money if the business hits the expected high-growth projections. An earnout reduces the risk of overpaying for a business.
THE TERMS OF AN EARNOUT
Every M&A deal is unique and therefore every earnout arrangement is unique. The specific terms of the earnout depend on the objectives of the buyer and seller.
These are the key terms included in any earnout agreement between a buyer and seller:
1. Contingent Purchase Price Consideration
The contingent purchase price consideration refers to the additional consideration payable to the seller regarding the sale of the shares or assets by the seller to the buyer.
In other words, this is the earnout portion of the purchase price to be paid to the seller by the buyer if the business achieves certain targets. The earnout is usually between 10% to 50% of the purchase price being deferred over the earnout period.
2. Earnout Trigger
Earnout agreements will typically detail different scenarios and which earnout will be triggered in each scenario. An earnout may be triggered when a business achieves specific financial targets such as revenues, net income, EBITDA, or EBIT targets.
Sellers tend to prefer to tie an earnout to gross revenues in earnout deals because it’s the simplest metric to measure.
3. Earnout Calculations
Once the metrics that trigger an earnout have been established, say, a certain amount of revenues or profits are achieved, then all parties must agree on how these triggers will actually be measured.
In some cases, the calculation may be as simple as checking the audited financials to verify revenues. Some earnout agreements even include complex financial formulas that will be used to calculate the earnout under different scenarios.
The objective is to cover all scenarios. Don’t leave anything to guesswork or interpretation by either the buyer or seller. Every scenario must be accounted for.
A typical earnout is structured over a 3-year to 5-year period after closing of the business acquisition.
5. Conduct of Business
The terms of an earnout will depend on which party will actually manage the business post-acquisition.
If the seller will manage the business, the buyer may be concerned that the seller will manipulate the earnout triggers to favor the seller. This could include understating expenses or overstating revenues in order to trigger a higher earnout for the seller.
If the buyer will manage the business, the seller may be concerned that the buyer will mismanage the business and cause the company not to achieve the financial or operational targets that would otherwise have triggered an earnout to the seller.
As such, every earnout agreement includes a clause about how the business will be operated post-acquisition. It usually also includes general statements that the operator of the business must manage the business in a manner that is in the best interests of all of its shareholders and that is not detrimental to the long-term value of the business.
6. Change of Control
An earnout can last up to 5 years or more. During that time, the acquirer may go through a change of ownership. It’s important that an earnout agreement account for this possibility.
In the event of a change of control created by an acquisition or asset transfer prior to the end of the earnout period, the acquirer is normally expected to provide some form of financial compensation to the seller.
The seller may not be willing to work with a new management team at the acquirer’s business. As such, sometimes the acquirer may be required to pay off the remainder of the earnout as soon as there is a change of control.
DISADVANTAGES OF AN EARNOUT
As we’ve seen so far, earnouts can be a great way to structure deals that work for the buyer and seller at the time. However, earnouts can be ineffective if they’re not structured correctly. They do have their limitations.
An earnout depends on what happens to the business in the future. Nobody can predict the future. This, in itself, can create problems.
1. Changing Environment & Changing Business Plan
Earnouts work best when the business will be managed exactly as envisioned at the time of the acquisition when the earnout was structured. They don’t work well in situations in which the business environment changes materially and the business is forced to change its business strategy.
If the business plan changes, then the performance of the business will change. These changes may not have been predicted or accounted for in the earnout agreement. The metrics such as revenues and profits that were supposed to trigger an earnout may be adversely affected. Thus, the seller may not receive the level of compensation that he should have received if the plan had stayed the same.
Outside factors such as an economic crisis or a change in industry trends or fads that neither buyer nor seller could have predicted can prevent the business from achieving its earnout targets.
This is a major problem with technology companies because the landscape changes so quickly. A tech company may have to change its business plan to survive or grow. The seller may be unwilling to change the business plan because it will negatively affect his earnout compensation. The buyer will suffer too because the business will lose value if it doesn’t adapt to changing circumstances.
2. Seller Control
In situations where the seller controls the business post-acquisition, the seller may implement business strategies that boost his earnout metrics but are not good for the long-term value of the company.
For example, if the seller’s earnout agreement states that he will receive compensation if the business achieves a certain level of revenues, he may spend more money than necessary to reach these targets. The business activities can hurt the bottom line of the business.
If the seller believes that changing the business plan will hurt his earnout, he may refuse to make changes that could benefit the business in the long term. The seller may continue to implement the original business model to the detriment of the business.
3. Buyer Control
In situations where the buyer controls the business post-acquisition, the buyer may implement business strategies that hurt the earnout metrics but are good for the long-term value of the company.
Buyers usually prefer net income as the most accurate reflection of overall economic performance. But net income can be manipulated by the buyer. The buyer could make capital expenditures during the earnout period that reduce its short-term profits in order to build long-term value.
If the seller’s earnout depends on a certain level of net income, then he receives less compensation if the net income targets are not achieved.
These are a few of the advantages and disadvantages of earnouts in technology mergers and acquisitions deals.