The Earn-Out Solution
If a buyer wants to pay less than what the seller wants to pocket, a valuation gap exists. However, an earn-out solution can bridge that gap. It can be a win-win situation, but it can also be a mistake waiting to happen.
Earn-outs can be a valuable feature of merger and acquisition deals. According to the 2011 Private Target Mergers and Acquisitions Deal Points Study by the American Bar Association's Business Law Section, 38 percent of private company deals (100 transactions closed in 2010) included earn-outs.
What is an earn-out?
An earn-out is a deal pricing mechanism where a portion of the purchase price is contingent upon certain post-closing events or targets being attained over a specified period of time, and paid at a later date. It is most commonly used in deals valued at less than $250 million. The earn-out amount generally represents 20 to 30 percent of the total deal consideration, but deals go as high as 40 to 60 percent. Earn-out periods are typically in the one- to three-year range.
When do earn-outs work best?
They are particularly useful:
• For a development or entrepreneurial stage business with limited operating history
• For new product lines or technologies
• For large projects or projects in the pipeline at the time of the acquisition
• For Markets or sectors where valuation multiples are reaching a peak
• To keep a seller with "skin in the game"
• If there is a private owner with "optimistic" projections
• For volatile industries and/or uncertain times
• For asset-light businesses
• For turnarounds
• When a buyer has limited access to funds
Earn-outs typically don't work in the health care industry because of federal fraud and abuse laws. They also are not appropriate under certain circumstances – for example, if the buyer intends to integrate the target company into its business.
How should earn-outs be structured?
For an earn-out to be a good resolution and not become a problem or area of dispute, it must be well thought out and documented. Every deal is different.
• Set realistic expectations. An estimated 50 to 90 percent of mergers and acquisitions fail to meet financial expectations, according to Jim Price of Business Insider. Because the odds of any acquisition succeeding are unclear, adding an earn-out only adds to the uncertainty.
An earn-out works only if the seller understands that part of the purchase price is contingent and the seller may never get it. On the flipside, the buyer must understand that the former owner will run the business to maximize the earn-out. Earnout terms need to reflect the proper motivations from each party's perspective.
• Keep it simple. Given all the variables, it is tempting to make an earn-out complicated with multiple goals and measurements. Simple is better. An easy-to-quantify metric is what is needed to be successful, such as a top line metric (e.g., revenues), an earnings-related metric or a non-financial metric (e.g., regulatory milestones). Independent of settling on a benchmark, there are plenty of other structural items to resolve – such as payments (timing, type and the number), floors and caps, the duration, security for the earn-out payment, "all or nothing," adjustments for integration, etc.
Even simple terms can become disputes. In July 2013, a unit of global construction conglomerate Foster Wheeler AG sued the former operator of a firm it acquired in 2009 over how the term "business" was defined in the earn-out. As described more below, keeping it simple doesn't mean failing to be clear.
• Keep some control. Most earn-outs are premised on the successor entity continuing to do what it has always done with a similar structure, but with more funds for growth. To the extent that major changes or loss of autonomy are expected, these items need to be identified and addressed. Some operating controls to be discussed are: future funding, expansion or consolidation plans, hiring, firing or the moving around of key personnel, restricting dividends or payments, product launches, taking on debt, keeping separate books and records, and getting board or informational rights.
• Document the deal. Keeping it simple doesn't mean keeping the paperwork to one page. Care must be taken to clearly and concisely set out the terms. Attaching detailed accounting principles and sample calculations to the contract are recommended. Attention to detail is very important and will likely help resolve issues efficiently and effectively. Leaving important words undefined usually results in disagreements. Not every aspect or word can be spelled out, but the exercise of discussing the terms and providing examples helps to flush out expectations and potential areas of dispute.
Dispute resolution is a vital element of earn-outs.
There are several tax and accounting aspects of any earn-out structure to be reviewed and factored in prior to any agreement on the earn-out terms. For example, inaccurate estimates of the fair value of the earn-out payments can lead to earning volatility under accounting rules (FAS 141R) or payments may be taxed as compensation income rather than capital gains. The tax and accounting treatment should not come as a surprise after the deal.
An earn-out can be a valuable solution in bridging the valuation gap. Competent legal, accounting and financial specialists can help structure an earn-out that will work. Failing to take the time and getting the advice to work through and document the earn-out will likely lead to a bad mistake.
As published, Daily Journal of Commerce, August 9, 2013.