Earnouts

Earnout Terms: Length, Buyer Restrictions, Measurement, Etc.

April 1, 2011 By Ney

I’ve spent a few blog posts on what situations earnouts are used and how often they are used. This last post on earnouts covers how to structure an earnout.

Earnout Period
In summary, make the earnout period not too short, not too long. Too short and the seller has an incentive to act in a completely short term manner, possibly playing games with trading long term revenue with short term. Too long and it can delay and impact the integration with the buying company and/or new owner. Earnout periods of eighteen months to 3 years are the most common, but of I’ve seen them out much further.

The length of the earnout also often depends and coincides with how long the seller is still involved in the business. Naturally, the seller wants some control of the company during the earnout period to make sure the company achieves the targets.

From a study of over 100 middle market transactions by the American Bar Association in 2009:

Under 12 months, 4.3%
12 to 23 months, 30%
24 to 36 months, 36%
Over 36 months, 29%

Amount of Earnout
It is hard to provide much guidance on the amount, since it completely depends on the deal and how much earnings risk the buyer is trying to mitigate. I’ve done earnouts of 10% of the purchase price to 50% of the purchase price, although 20 to 30% are more common.

Earnout Measurement
A buyer will commonly wish to base an earnout on EBITDA because, after all, that is really what he cares about. A seller’s most common fear is that even if they are still around they will not have complete control over costs and therefore can not control EBITDA. Indeed, an experienced deal attorney once told me this is the issue that causes the most lawsuits after a deal is closed.

For this reason we try hard to negotiate earnouts based on revenue milestones, not EBITDA. If we fail at that, gross margins can also work. Basically, the further up the P&L statement you go, the easier it is to measure earnout.

Interestingly enough, we had a situation where measuring earnout as a percentage of EBITDA was the best solution for the seller. In this case, the seller was performing a myriad of illegal tax maneuvers to lower his taxes, and try as I might, I could not convince him to stop for even one year (for he would pay 40% in taxes, but would receive 400% in increased purchase price for each dollar earned). He admitted that all this would end when the buyer bought the company, and then the buyer would receive a windfall because EBITDA would almost magically be higher. So we negotiated an earnout on an increase in EBITDA, not in revenue and not in gross margin.

You can also measure earnout on events such as signing (or often resigning) a major contract, getting government approval (e.g. FDA approval) or launching a new product.

From two studies of over 200 middle market transactions by the American Bar Association in 2007 and 2009:

Earnout based on Revenue: 29%
Earnout based on EBITDA: 32%
Other: 26
Unknown: 13%

The transactions in the study were between $20 million and $500 million in size – fairly large. I thin a similar study of smaller deals would find that the use revenue as a measurement occurs more often than the use of earnings.

Earnout Formulas
It is also good to keep in mind that complex formulas based on revenue, gross margins or earnings are problematic when it comes to actually writing a purchase agreement and making sure that months later everyone that reads it will come away with the exact same understanding. It is pretty easy and even fun to brainstorm and draw out graphs and curves, and talk about cliffs and caps. But always keep in mind that you should keep it as simple as possible and that complex agelbra doesn’t translate well into a legal agreement.

Controls and Restrictions
A seller will often say something like, “OK, I’ll live with that earnout based on growth of 15% next year, but in return I want some reassurances – in writing”. These are some of the restrictions or buyer covenants that are often put into place during the earnout period:

Office will stay in same location
Key employee(s) will not be terminated
Sales compensation structure will remain the same
A certain amount of capital be invested in a project

However, each restriction is a negotiation in itself, which is another reason to keep everything as simple as possible. For example, it is easy to say that a key employee can not be terminated, but what if he commits extortion? You can say that sales compensation will remain the same, but the new company has a different healthcare package they use, and the fact is that some employees can get very passionate about their coverage, personal doctor, etc. You could argue this changes the compensation, so this issue needs to be addressed and covered in the purchase agreement.
In other words, the issues that need to get worked out in earnouts tend to run much deeper than many originally think about. In fact, it isn’t uncommon for earnouts to disappear late in negotiations when the parties figure out there are just too many issues to address and the complexities become apparent.

How Common Are Earnouts?

March 24, 2011 By Ney

How often are earnouts used? Small businesses generally don’t use earnouts and for good reason. In small business transactions there are typically short transition periods (usually sellers “earn” an earnout by staying during a transition), financials are often fairly messy so measuring earnout milestones are problematic, and buyers usually want to come in and operate the business as theirs without any of the operating limitations that often occur with an earnout arrangement. They occur with small businesses, but it is not common.

However, they are fairly common for larger companies in the lower middle market and middle market. Valuation gaps between buyers and sellers are common, and that naturally leads to discussions on earnout.

It is also fairly common for earnouts to disappear later in negotiations when the challenges of actually structuring the earnout become apparent. For example, how to measure the earnout, how long to make the earnout period and what operational limitations will be placed on the buyer are all typical issues to be worked out with earnouts (my next blog post will look at these in more detail.)

For example, last year I did a deal in which there was initially an earnout. During last minute negotiations with the two buyers still left bidding, one of the buyers dropped the earnout and made that payment a non-contingent note. That swung the deal his way and the next day the seller signed that buyer’s LOI. It also simplified the purchase agreement that would soon come.

The American Bar Association puts out a deal points study in which they organize deal information from a number of middle market deals. In 2007, they analyzed 103 deals and 20% of those deals had earnouts structured into the agreements. In 2009, 104 deals were analyzed and 29% had earnouts, which makes sense given the higher volatility and risk of earnings in 2009. Those deals were squarely in the middle market between $20 million and $100 million. For lower middle market deals at $20 million and below I think there are around 50% of deals that have earnouts.

Earnout Series: How to Tell if an Earnout is in Your Future

March 21, 2011 By Ney

Some of my clients tell me they would never accept an earnout, but then go on to say how they believe the historical earnings don’t tell the whole story and that a buyer needs to believe the company will grow in the future. In other words, pay more. Unfortunately, many buyers will say, “I don’t quite believe you, prove it”. And that’s an earnout. Here is how to tell if an earnout makes sense when you sell your business.

When are Earnouts used?

An earnout is contingent future payments based on performance milestones. For example, in a simple earnout arrangement an extra payment of $100,000 to the seller may be “earned” by growing the company by an additional $1 million in revenue in the 12 month period after the close of the transaction. Earnouts are used when there is a difference of opinion on what the earnings will be in the future. The buyer says, essentially, “show me”. Earnouts are well known in the technology sector; however it really has more do with high growth scenarios than technology.

Business are Bought for Future Earnings

In looking at Earnouts, it is useful to remember that what a buyer really cares about are future earnings. Since we don’t know what future earnings will be, we generally use historical earnings for valuation. Earnout discussions naturally arise when there is a significant difference between historical earnings and future projections.

Let’s look at a few scenarios of historical vs. projected earnings.

Scenario One – Stable Earnings

This company has a stable history and a believable projection. It isn’t hard for anyone to believe that projection. In other words, the risk is fairly low, and the seller should not expect an earnout.

The purchase price in this case should be comprised of cash and possibly a note, but unless there are other risks, the note shouldn’t be contingent on revenue or earnings – and there should not be an earnout.

Scenario Two, Supported Growth

In this scenario it is also easy to see where earnings are heading – up. In other words the projection of future growth is clearly supported by historical trends. However there is often some discussion about who is going to benefit from the growth. A seller may say, “You can see what will happen, so I want to base the purchase price on a high multiple, or possible use next year’s earnings”.

A buyer, on the other hand, may say that if the company grows, it will be because of his effort after he buys the company, not the sellers. After all, he certainly isn’t buying it to give all the earnings to the previous owner.

A smart seller will counter this by explaining that much of the future growth is because of the foundation he has built. The website, reputation, product, service, etc. have all come to together to build momentum that would be difficult to stop. However, what he is also saying is, “Just trust me on this”. No one likes to bet hundreds of thousands or even millions trusting someone you recently met, so earnout discussions start.

In this type of scenario, an earnout could look like the following:

A “base price” of cash and notes is calculated using historical performance, and an earnout is structured based on the company hitting certain targets. The target may be a revenue or earnings milestone or just about anything that makes sense. The next blog post will cover typical earnout stuctures.

Scenario 3, Unsupported Growth

We often (too often) see a scenario where the company doesn’t really have an upward trend, yet the business owner believes there could be a lot of growth opportunities. For example, the owner may say, “I never got around to putting up a website but if you built a website and sold products online, sales would double.” In this case the buyer does have a pretty good case to say, “Well, if I spend the money and time to build the website, then I should enjoy the rewards”.

Sometimes we can negotiate an earnout in this type of scenario, but it really depends on the situation and why exactly the seller believes growth is inevitable.

Scenario 4, Recession Proofing a Transaction

Although earnout agreements are mostly seen in growth companies, we’ve also seen it a few times in protecting the buyer from further decline during the recession. Many companies have seen a retraction of sales and earnings from the time before the recession, and that is just fine with buyers – as long as the performance has stabilized. We’ve seen buyers, fearful of further decline, set a purchase price on a lower “base” number, then set up an earnout target of simply staying put. In other words, if the business does the same in revenue and earnings in the future, then additional payments are made to the seller. If the business slides some more, then the seller gets the “base” price that was somewhat lower.

In the next few blog posts, I’ll cover how frequently earnouts happen, and how they are typically structured.