4 Steps to Structuring an Earn-Out Agreement: Part 1 – Measurement

By Generational Equity

07/26/2017

“Earnouts can be wonderful deal provisions, but the key is that they must [be] kept simple and be based upon easily measurable metrics…”

When you are ready to exit your business, there are several ways to structure a deal. Today, a deal will often involve incremental payments, clauses and other conditions rather than just a lump sum. Our M&A advisors recommend to lay out any deal as simply as possible, so both acquiring and exiting parties understand the terms of the agreement. This point is amplified when an earn-out is involved.

An earn-out can help bridge a gap in valuation between a buyer and seller. Instead of a single payment, the buyer will initially pay a percentage of the agreed price, with the remaining value paid once certain obligations are realized post-acquisition.

For example, say a company is valued at $10 million, but because of risk associated with the future projections of the company, a prospective buyer wants to pay just $5 million. An earn-out could close this gulf – the buyer pays the initial $5 million, with the remaining price paid  contingent upon the company reaching agreed to levels of revenue and/or earnings (or other metrics) over a specific time frame.

Compromise is invaluable in closing a deal, especially if it helps limit the risks a buyer could associate with a purchase. As such, a payment model that is applied post-acquisition can help reassure buyers about your company growth, and secure you a better overall return on investment. But, there are risks associated with earn-out agreements.

As Richard Parker discussed in his article for Forbes:

“Earnouts can be wonderful deal provisions, but the key is that they must [be] kept simple and be based upon easily measurable metrics such as revenues or customer count, or profitability as long as there is a pre-determined formula to calculate it.”

This four-part series will provide an in-depth introduction into the potential pitfalls of earn-out agreements. We hope this provides the guidance you need to pursue these deal structures with confidence when you choose to exit your company. In this first piece, we consider a valuable starting point – what are the conditions of your earn-out.

What will your earn-out agreement be judged against?

“They say too many cooks spoil the broth, and too many conditions spoil your chances of a fair earn-out agreement.”

Now, this feels like the logical first step of these negotiations: what conditions will you, the company owner, need your business to fulfil to achieve the biggest return? This will be the foundation of your earn-out provisions, so it is essential that it is approached with due care and attention. Our dealmakers, having handled many of these agreements in the past, champion this piece of advice:

KEEP IT SIMPLE

They say too many cooks spoil the broth, and too many conditions spoil your chances of a fair earn-out agreement. Therefore, it is important you have a clear understanding of the terms you will need to fulfil to guarantee the full price for your business. Each condition you add as part of the arrangement makes it that much more difficult to hold up your end of the bargain.

So, what metrics do you choose? The 21st National M&A Institute of the American Bar Association (ABA) offered numerous examples of measurement standards in earn-out agreements, including but not limited to:

• Revenue
• Gross Profit
• Operating Profit
• EBIT
• EBITDA
• Net Income

It is important to remember that not all deals are based on purely financial measurements – you might be expected to execute a contract, or complete the development of an important product. It is about choosing the right conditions for your financial future. Our advisors at Generational Equity recommend no more than one or two – the simpler the better so all parties recognize what the end goal is.

“While earn-outs offer attractive potential for more appropriately valuing a company, they also present significant risk of manipulation and post-closing dispute.” Source: Schwabe.

But it is not just how many you choose, but which ones you choose. This choice is about guaranteeing fairness, which can be a challenge on both sides. For instance, revenue growth is an easily measurable indicator, but it could be hiding holes in a business’ bottom line. Conversely, net income is a more accurate assessment of profitability, but could be manipulated by unnecessary expenses once the deal has been concluded. It is essential to negotiate the best compromise for all parties, and establish an impartial referee to ensure fairness, whether the business reaches its expectations or not.

Our final recommendation in this part is establishing tiers in your deal structure. While we want to keep things simple, this will be key in ensuring your earn-out isn’t all-or-nothing. Say we take the earlier example: if the company’s revenue doubles post-sale, you receive the full $5 million expected. But, if it grow only grows by 50%, you arrange for this to be worth $2 million rather than nothing. This way, you are safeguarding against unforeseen circumstances and other factors that could stop you reaching expectations.

We hope you enjoyed this first in-depth exploration into earn-out agreements and how it is crucial to establish how they will be measured. In our next piece, we will go into greater detail of the importance of determining the true value of your company before entering any arrangement. Alternatively, you could consider attending one of our executive conferences. These offer you a complete breakdown of the M&A process, including information on earn-outs, and provide useful strategies to prepare for a successful exit.

For more information, you can reach us on our dedicated contact page.