How Your Banker Can Help Maximize Your Earnout in a Sale Transaction / Part 1 of 2
Navidar | January 18, 2022
In this two-part post, we discuss earnouts, how they can be used effectively, the experience of Navidar’s clients with earnouts, and, perhaps most importantly, what specific steps sellers and their bankers can take to maximize the full earnout amount.
By way of background, an earnout is a contractual mechanism in a merger or acquisition agreement that provides for the payment by the buyer to the seller’s shareholders of an additional amount of contingent consideration, either in cash or in stock or a combination of the two, if certain agreed-upon milestones or metrics are achieved by the seller in a specified period of time after the acquisition is completed. Earnouts are referred to as contingent consideration because the payment of the earnout, if any, will depend upon—that is, it is contingent upon—the achievement of the agreed-upon milestones or metrics. Earnouts can involve varying periods of time, sometimes for as short as six months and other times extending multiple years.
A great deal has been written about earnouts in M&A literature and the term “earnout” often elicits strong feelings from both sellers and buyers. For some observers, earnouts have a negative reputation, involving broken promises, unearned consideration, money left on the table, and soured relations after the deal has closed. However, Navidar’s experiences with earnouts for our clients have been exactly the opposite.
Why Navidar’s Clients Have Had Overwhelmingly Positive Experiences with Earnouts
Navidar’s experiences with our sell-side clients have been incredibly positive along several important dimensions:
- Earnouts have been a part of the deal for our clients in about 30% of our sale transactions, which seems consistent with market statistics indicating that approximately one-third of deals involve earnouts.
- The earnout component of our sale transactions accounted for an average of 19% of the total deal value, which is on the lower end of the 20% to30% market range.
- Most critically, Navidar’s clients have received 89% of the total available earnout dollars that they could have achieved, which is a considerable accomplishment. This result stands out against the estimated 50%to 90% of mergers and acquisitions that fail to meet financial expectations.
- In those situations where the earnout represented more than 20% of the overall consideration, all our clients have achieved their financial projections and have received 100% of the agreed-upon earnout payments.
- Finally, and very importantly, our sell-side clients have never had to resort to litigation to receive their contractual earnout payments, despite the familiar quip that earnouts are just disagreements about deal valuation at closing deferred to future litigation in a courtroom after closing.
A Differentiated Approach Creates Better Client Outcomes with M&A Earnouts
In the remainder of part one of this post, we describe three of the seven key elements of our approach to earnouts and also provide insights that our team of bankers at Navidar has gained from their experiences negotiating M&A earnout provisions in various sale transactions.
1. Tailor Earnouts to the Situation at Hand. To be clear, in certain cases, the best approach is to have no earnout at all in the deal. Earnouts should not be the first option in most M&A transactions, but we believe that there are certain cases where earnouts are an important tool that can help to complete a mutually beneficial transaction. When structured correctly and given the focus they deserve, earnouts can provide valuable additional compensation to sellers after the deal closes and so should be a standard part of every banker’s M&A toolbox.
In our view, there are several situations where earnouts can be useful. First, one situation that we see often in our sale transactions involves the buyer wanting to incent the management of the seller to achieve the strongest possible financial results after the acquisition has closed and after paying a full and fair cash amount at closing. In this case, using an earnout structure to reward the seller’s management team for accomplishing certain important objectives after the deal makes total sense. Another variation of this is when there is a specific risk noted and the buyer wants to ensure that the seller effectively manages this risk. Examples of risks include a large contract coming up for renewal, a large contract in the pipeline yet to be won, or the potential release of a new product. Second, and the case that unfortunately gets the most attention, is when buyers and sellers do not agree on the appropriate value for the company. In this case, too, an earnout can be an effective bridging mechanism, though Navidar prefers to use earnouts more often in the first case where the buyer wants to incent the acquired management team.
In our experience, buyers of our clients have been pleased to make the agreed-upon earnout payments because it has meant that the sellers achieved their milestones, thus making the acquisition even more successful for both the seller and the buyer after closing.
2. Make Earnout Milestones Simple and Specific. We strongly advise our clients to focus on the simplest and most specific earnout milestones possible. In the context of an earnout, this means focusing on metrics that are clear and easily measured. These metrics might include the number of units sold, gross revenues, or net revenues. These metrics are far more objective than other potential milestones, such as EBITDA, which involves a large—and in our opinion unacceptably broad—range of interpretations and opportunities for manipulation. While it might be tempting to try to engineer complex and complicated earnout metrics to cover as many different scenarios as possible, doing so is usually not a good idea. Instead, taking the time to carefully select the simplest and most specific milestones and metrics upfront avoids many potential problems on the back end.
3. Avoid the “Garbage In-Garbage Out” Trap Involving the Seller’s Financial Model. In the context of an M&A earnout, avoiding a “garbage in-garbage out” situation means making sure that your financial model and projections are credible and present achievable results. We do not believe it is an exaggeration to say that a successful earnout starts with a realistic and defensible bottoms-up financial model and we take a great deal of time to collaborate with our clients to create one that is driven by detailed and clear business metrics that can be defended. As we say, time spent with your banker on creating your financial projections early on pays huge dividends during negotiations with sellers and maximizes not only the chances of getting your deal successfully closed but also of earning any post-closing earnout payments that may be part of the transaction.
We have heard that sellers sometimes create unrealistic and difficult to defend financial projections based on their bankers’ belief that “the buyer is going to discount what we say anyway,” and so mistakenly conclude that it makes sense to unjustifiably inflate their financial projections. This creates the much derided “hockey stick” projections where, for example, future sales grow far more rapidly than they ever have grown historically. Unfortunately, taking this approach ultimately hurts the seller’s credibility and diminishes the buyer’s confidence. This diminished confidence can in turn encourage the buyer to “call the seller’s bluff” and insist on using the seller’s overly aggressive financial projections as the basis for any earnout milestones, which of course will not be achievable given that they were not realistic in the first place.
The truth is that buyers do not discount credible financial projections. Our experience has been that buyers usually discount sellers’ future financial projections only when those projections are unreasonable, unsupported by clear metrics, or cannot be logically defended by the sellers.
We strongly recommend to sellers that they create achievable and realistic financial projections that can be well-defended during due diligence. Your banker must have proven expertise and demonstrated experience in creating realistic, bottoms-up financial models and be willing to work closely with you and your team to create these models. When this happens, we have had buyers tell us that they appreciated the realistic and defensible financial projections, and this has facilitated our achieving excellent valuations and outcomes for our clients.
A final point: Do not make the mistake of relying on assumed deal synergies to make your earnout milestones. Because post-closing merger integrations can take longer than anticipated, especially within large acquirers, the seller must rely on its base case projections as the basis for earnout milestones. In part two of this post, we will discuss four additional key elements of Navidar’s approach to negotiating M&A earnout provisions in sale transactions.
If you would like to discuss any of the advice provided above, or if you are currently seeking counsel on a potential M&A transaction, please contact Stephen Day at [email protected] or (512)765-6973.