In the world of mergers and acquisitions (M&A), structuring a deal that satisfies both the buyer and the seller can be a complex endeavor, especially for small and mid-sized companies. One strategy that is often employed in such transactions is the use of earnouts – a mechanism that allows for contingent future payments of a portion of the purchase price based on the achievement of predetermined performance metrics. Let's delve into why earnouts are used, their pros and cons, and the importance of clarity in metric selection.

Why Earnouts?

Earnouts serve as a bridge between the expectations of buyers and sellers, particularly when the parties have a difference of opinion as to the valuation of the target company. For small and mid-sized companies, where financial performance can be more variable and projections less certain, earnouts offer a way to align incentives and share risks between the parties involved.  By including an earnout in the transaction, a portion of the overall purchase price is not paid to the seller at closing, but instead is deferred and paid at a future time so long as specified metrics are achieved.   Earnouts can be structured in creative manners, including future cash payments and/or equity grants to the seller or its principals.

Rationale Behind Their Use

1. Risk Mitigation.   Earnouts help mitigate the risk for buyers by tying a portion of the purchase price to the future performance of the acquired business. This incentivizes sellers to maintain or improve performance post-acquisition.  Often, the key principal(s) of the seller will be employed by the buyer post-closing, to provide transition assistance, training and leadership for a specified period of time.   By including an earnout in the transaction structure, the seller's principals will be motivated to ensure that the buyer is successful, and that their transition services will be top-notch.   

2. Bridge Valuation Gaps: When there's disagreement on the valuation of the target company, earnouts provide a compromise by allowing sellers to capture additional value if certain milestones are achieved after the closing of the transaction, and by allowing buyers to pay a lower purchase price if the stated milestones are ultimately not achieved. 

Pros and Cons of Earnouts in M&A Deals

Pros of Using Earnout Structure:

• Alignment of Interests: One advantage of an earnout is that both parties are motivated to work together to achieve common goals, fostering collaboration and integration post-acquisition.
• Flexibility:  Earnouts offer flexibility in structuring deals, allowing buyers to conserve cash upfront while providing sellers with the opportunity to realize additional value later, once the specified metrics are achieved.
• Deal Closure: Earnouts can facilitate deal closure by bridging valuation gaps that might otherwise derail negotiations.  When an earnout structure is used, buyers bring less cash to the closing table.  

Cons of Using Earnout Structure:

• Complexity: Earnouts add complexity to M&A transactions, requiring careful negotiation and drafting of contractual terms.
• Disputes: Disputes may arise over the interpretation of earnout provisions or the achievement of performance metrics, leading to potential friction (potentially including litigation) between buyers and sellers.   Although sellers are often involved to a degree in the business on a post-closing basis pursuant to a transition services or consulting agreement, the ultimate decision making authority always rests with the buyer after the transaction has closed.  As a result, sellers can effectively be powerless in terms of the direction of the company and whether the company will in fact achieve the metrics needed for payout under the earnout.  
• Uncertainty: The future performance of the acquired business may be uncertain, leading to ambiguity and risk for both parties.   When an earnout structure is used, sellers must understand that payout under the earnout is not guaranteed.  

Clarity in Metric Selection

To mitigate the risks associated with earnouts, it's crucial to be objective and clear in the metrics used for payout. Common metrics in small and mid-sized company M&A deals include:

- Revenue Targets
- EBITDA or SDE 
- Customer Retention Rates
- Product Development Milestones
- Profit Margins

By selecting metrics that are measurable, objective, and within the control of both parties, you can minimize ambiguity and the potential for future disputes.

Conclusion

While earnouts can be a valuable tool for bridging valuation gaps and aligning incentives in M&A deals involving small and mid-sized companies, they come with their own set of challenges. Careful consideration of the rationale behind their use, along with clear and objective metric selection, is essential to maximizing their effectiveness and minimizing risks for all parties involved.

The Law Office of Jennifer M. Settles represents buyers and sellers in M&A transactions, and assists parties in earnout clauses and other pertinent aspects of their deal.   Contact us today at (602) 617-3938 or through our website at www.jsettleslaw.com, for more information and to schedule a FREE consultation.  

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