The Philosophy of Earn-Out deals

The concept is quite simple. The buyer’s perception of value is lower than the seller’s aspiration on price. This gap is usually fueled by differing views on the potential growth of the target company.

The acquirer may be concerned about the dependency on certain customers, or some of the owners or the success of new service lines. This view is reflected in the value the business buyer perceives today regarding that specific target. Hint, to avoid earn-outs, owners of private businesses should strip out as much dependency from their business as is humanly possible. (That’s one of our main objectives when we’re hired to scale businesses). It’s almost inevitable that the shareholders of a private business have aspirations on price higher than the acquirer’s perception of value. The future looks slightly (or materially) different depending on which end of the telescope you’re looking!

There you have it, the future value gap. The earn-out attempts to wrap a formula around that gap (could be profits, gross profits, sales) and pay outs are based on achievement of predictions being achieved.

These techniques were famously used to build up large service groups eg WPP, the world’s largest advertising agency. There is an important negotiation point worth stating. The earn-out amount is in addition to the up front sum paid to gain 100% of the shares. The earn-out doesn’t buy the buyer any more shares. The 100% of shares are bought by the up front sum, with a contractual agreement to pay more if key conditions are met. That means if you are an owner of a company, private or public you expect the buyer to show full respect for what the target has achieved to date, within the up front sum. The battle of minds should be around a fair price for today’s achievement and therefore earn-outs should relate to incremental performance beyond today.

Seems obvious but often lost in the emotion of deals.

Structuring Earn-Outs

A worked example is always easier to understand. Private selling company, Aspirational Inc. has produced EBITDA of $10m during the previous financial year and their 3 year forecasts suggest future profits of $12m, $13m and $16m as new products come on stream.

The following structure attempts to produce a win:win. The seller gets full respect for results to date but also some more upside if the business delivers the forecasts. From a buyer’s perspective the deal looks attractive and safe.

  • Pay $117m which looks fair at EBITDA of 11.7 but structured as:
  • Up-front $80m, EBITA multiple of 8 times historical earnings
  • Earn-out formula 10 times (average of projections > $10m) eg 10($13.67m-$10m) = $37m
  • Total consideration if targets are met $80m plus $37m = $117m, but as the acquirer, you own a business producing $16m profit
  • Initial EBITDA multiple = 8, Exit multiple (when you have stopped paying) 7.3

However let me tell you from a seller’s perspective why I’d want more. The formula is fine but the multiplier doesn’t reflect rarity value. A business producing EBITDA of $10m and growing, is a rare beast. Ask any Private Equity House chasing deals. Remember there are only 18,000 companies in the US employing 500 people or more. If this was a SaaS business, let’s say the EBITDA margins were 30%. That would translate to a sales run rate of at least $30m and a multiple of 4 times produces $120m up front. So the ball park value of $117m may not be far off but the question remains, what is the value to a specific acquirer?

Rules to document

Because earn-outs are being executed when the buyer has full control of the business it is important that sellers build protections into the Purchase contract:

  1. Accounting policies to be used
  2. Management charges from the buyer eg payroll, legal, treasury services
  3. Intra group pricing to be deployed
  4. Cost of finance provided by the buyer
  5. The appointment of auditors
  6. Rules concerning changes to staff

The key to these rules is to avoid arguments post acquisition. Imagine the post acquisition strategy and legislate for the obvious.

Issues to negotiate

  1. Earn-outs do not work in every case. if you intend to totally integrate the acquired company from day 1, earn-outs around profits are impossible.
  2. Remember an earn-out effectively ring fences a target company until the deal is paid out. Gross margin & sales earn-outs do allow some integration post acquisition.
  3. Salaries can’t be artificially held down by the seller to pump up profits.
  4. When things go wrong, don’t hang around, post acquisition, move in and fix the problem.
  5. Long earn-out deals never work. Max time 3 years but probably better with two.

Like all deal structures, it needs to be based on a logical integration strategy that works for both sides. They can work, but they require a fresh approach to be taken on every deal.

The Portfolio Partnership runs smart, incisive, practical in-house acquisition workshops, based on our recent, highly acclaimed book, The Acquirer’s Playbook. More details here.

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