An earn-out bridges the gap between the two valuations
and requires the sellers ‘earn’ part of the purchase price based on how well the business performs after the sale.The seller will only receive this additional portion of money if the business performs at a level agreed to during the acquisition negotiations.
According to the results of the research conducted by Ninon Kohers and James Ang, Earnouts in Mergers: Agreeing to Disagree and Agreeing to Stay, published by The Journal of Business, The University of Chicago Press, earn-outs serve two main functions in mergers: 1) as a risk-hedging mechanism for bidders in mergers with high information asymmetries, and 2) as a retention bonus for valuable target human capital.
Rationales for an Earn-out
The above mentioned research found that there are two main reasons to structure an earnout when buying a business:
Reducing asymmetric information
A two-part payment contract consisting of a partial up-front amount and a later earn-out payment that depends on ex post results may resolve disagreement between bidders and targets in mergers and acquisitions in expectations about the target’s true value.
Specifically, the initial up-front payment would reflect the agreed-on portion of the transaction value, while the size of the second-part payment would be a function of the extent of the disagreement between the target and the acquirer. Thus, the bidder bears no risk of overvaluation because the earnout contract acts as a risk-reducing mechanism to hedge against the risk of paying too much for the target.
Encouraging management retention
The human capital of target managers can be a valuable component of the target’s value and, thus, may be priced as part of the merger premium. Consequently, the value of the target in the merger may be conditional on retaining the manager.
Since the valuation of the target could depend on the target manager’s behavior during the transition period, earnout contracts would help to keep the target’s owner/manager ‘‘in line’’ by effectively requiring them to honor a non-compete contract and to exert the maximal effort to manage the business and deliver the promised results.
Users of Earn-out contracts
According to the results of the referred research, earn-out mergers tend to involve smaller, privately held targets and divested subsidiaries in high-tech industries, for example, computer technology and biotechnology, and business related service areas. Furthermore, the majority of takeovers using earn-outs are between acquirers and targets from different industries, often with little integration occurring between the bidder and target after the merger is completed.
Merger and Acquisitions situations with large information asymmetries may include acquisitions of firms with high-growth opportunities (e.g., high-tech firms), firms with low tangible assets (e.g., firms in service industries), or companies with little or no previously disclosed information (e.g., privately owned businesses or subsidiaries of other companies).
Also, the levels of asymmetric information would also be elevated for bidders making acquisitions in unfamiliar territories, such as in unrelated cross-industry or cross-country acquisitions.
Finally, bidders that can least afford to absorb misvaluation risk (such as smaller bidders) or bidders that face relatively large magnitudes of this risk (e.g., when the target’s transaction value is large relative to the size of bidder) would have the greatest need to use a contingent contract to hedge away the risk.
Structuring the Earn-out deal
The results of the research by Kohers and Ang show that while earn-out contracts have the potential to reduce valuation problems, the high transaction costs or costs of implementation may prohibit the use of this payment method in many cases. For example, agreeing on the appropriate performance standard and then measuring the ex post results may pose serious difficulties. Furthermore, third-party verification of the results and enforcement of the contract through legal means, actions that may be necessary in some cases, would also seriously complicate the feasibility of using earnouts.
Thus, in addition to the existence of severe information asymmetry between the target and bidder and the presence of valuable target human capital, the feasibility of writing such a contract is also a necessary condition for observing earnouts in practice.
There are key factors to consider from the beginning when structuring an earn-out:
- Setting Realistic Expectations
When there is a gap between the target and a potential acquirer in the perceived value of a business, it is usually caused by the expected future growth of the company. Being equipped with solid expectations for the businesses success over the next five years can prepare target owners well for negotiating an earn-out. To make a good deal, it is necessary the terms of the deal involve realistic expectations of growth and profit.
- Planning on working harder after the acquisition
When structuring an earn-out for a business, the owners should be prepared for a stressful period during the transition where certain milestone need to be achieved within a 2-3 year time frame. If they are not willing to stay on and run the place, all the while keeping the earn-out expectations in mind, then it’s time to look at other sale options.
- Some questions to be answered at early stage
What portion of the sale price the owners are willing to risk, and to work for during the transition period? The length of the transition period, How long are the owners willing to stay on? Can they meet the milestones in that timeframe? There’s any range of terms that the acquirer and the seller might consider? For example, the buyer might agree to pay 80% of the total price upfront, with the remaining 20% paid in stock or cash after the transition period. Or the deal could split the sale price 50/50 over a 5-year period, which is the timeframe the target owners have to optimise the business’s performance.
- Keep it simple
Earn-outs are most effective as an incentive for the seller when the size of the payout is determined based upon one or two simple variables that are easy to understand, such as increased profits or customer base.
- Keep the key players
If other executives were integral to the company’s growth and success, will the company be able to function under new ownership without them? If not, it is necessary to lock them in, too.
- Make sure who has control
Ensure that the contract expressly states who will oversee any departments that will be executing on the goals and standards set forth in the earn-out.
- Ensure that incentives are in place
The earn-out percentage should be high enough to keep sellers from losing interest, especially in the event of a setback. Also, make sure to create contingency plans to address the most unlikely of scenarios – especially if you’re entering into a long-term earn-out deal.
So long as it is structured correctly, an earn-out can be a beneficial agreement for both parties; the seller is able to prove the value of their business and achieve additional compensation in the process, while the buyer eliminates some of the risk associated with the purchase should the company fail to perform after the transaction. An earn-out gives the seller an added incentive to ensure the success of the business going forwards. Should the business not perform as the buyer expected then they have been given some protection against overpaying.