In mergers and acquisitions, bridging valuation gaps between buyers and sellers often requires more than just financial acumen—it demands creativity. A key strategy is the use of earnouts, which can alleviate buyer concerns and reward sellers for consistent performance or growth going forward. This post delves into the nuances of earnout structures, shedding light on how tailored arrangements can facilitate deal-making by ensuring a fair and achievable path to value realization.
The Essence of Earnouts
An earnout is a contractual provision stating that a seller of a business receives future earnings if the business achieves certain financial goals. The essence of an earnout lies in its ability to mitigate buyer risk while offering sellers the opportunity to earn a portion of the purchase price based on the future performance of their business. Whether pegged to revenue, gross profit, or EBITDA, these structures serve as a bridge, closing the gap between differing valuation perspectives.
While revenue and gross profit-based earnouts are often favored for their straightforwardness, minimizing disputes post-closing, the true artistry in earnout structuring emerges in its flexibility. From 'all or nothing' targets to layered or ratio-based payouts, the earnout can be crafted to suit the specific concerns and aspirations of both buyers and sellers.
The Delicate Balance of Opportunity and Risk in Earnouts
Earnouts are pivotal in bridging valuation gaps, however, they inherently bear risks. Rarely are earnouts desired by sellers. The dependency on future performance means sellers might not receive full payment if targets aren’t met, a situation complicated by sellers’ lack of control post-acquisition. Misalignment between expected and actual performance can lead to disputes, especially when reasons for underperformance—be it market downturns or management decisions—are subject to interpretation. Therefore successful earnout structures hinge on clear and well-defined targets and evaluation methods, ensuring both the buyer and seller remain in alignment.
Crafting the Earnout: A Case of Tailored Solutions
There are three main components to align sellers and buyers when it comes to crafting an earnout. It is important to start with understanding the monetary gap the earnout needs to cover. Next, it is necessary to establish a mutually agreeable time frame. Finally, there needs to be an understanding of which metric is of concern in terms of continuing or growing in performance.
Consider implementing an earnout strategy to bridge a valuation gap of $2M distributed over 5 years. The aim is to structure the earnout so it generates $400k each year, underpinned by the consistent performance or growth of a chosen metric—in this case, revenue. Below are a few scenarios demonstrating how this approach could be effectively applied:
- All or Nothing: If annual revenue hits or exceeds $20M, the seller receives a $400k payout each year for five years.
- Layered Payouts: Reaching $20M in sales triggers a $400k payout; surpassing $22M increases it to $500k, and soaring past $25M elevates the payout to $600k.
- Sliding Scale: The earn-out constitutes 2% of revenue, potentially capped at a maximum threshold, say, $50M.
In every scenario, the buyer should ensure that the cash flow can sustain these earnout payments alongside their debt obligations. While the intricacies of earnout agreements can spiral into complexity, the golden rule is to maintain simplicity for clarity and ease of execution.
Earnout Structures in Action
Recent Calder deal-making showcases the versatility of earn-out structures. For example:
- Structured Milestones: In one deal, two installment payments were contingent upon the acquired business achieving specific gross revenue targets in consecutive years.
- Graduated Payouts: Another arrangement set a base payout for reaching a minimum gross profit, with additional increments for exceeding that threshold, subject to a cap.
- Percentage-Based Payouts: A different deal offered sellers a percentage of net revenues exceeding a predefined threshold, capped annually and over the total earn-out period.
Conclusion: The Art of the Earnout
In the realm of M&A, earnouts represent more than mere financial instruments; they are a testament to the power of creative problem-solving. By carefully designing earnout structures that align with the strategic objectives and risk appetites of both buyers and sellers, parties can bridge valuation gaps, fostering a cooperative atmosphere that paves the way for the successful integration and growth of the combined entity.
About Calder Capital
Founded in 2013, Calder Capital, LLC is a lower middle market investment bank providing mergers and acquisitions advisory services to business owners, entrepreneurs, family offices, and investors across the United States. Our dedicated team of professionals combines extensive industry experience, technological innovation, negotiation savvy, and key relationships to exhibit exceptional execution. Calder’s services include mergers and acquisitions advisory, private funds and capital markets advisory, and business valuations.