M&A earnouts and the impact of COVID-19

As it pertains to transactions, an earnout is basically an agreed-upon payment to the seller contingent on future events, or for future conditions being met.

For example, in its simplest form, let’s say a company is being sold and the two parties agree that when the company hits $10 million in revenue, the seller will receive an earnout of $250,000. That is just one type of earnout, as they can vary greatly in size, structure and complexity.

As far as why earnouts exist, the simplest explanation is that buyers and sellers often differ in their future expectations of a business. Earnouts help “bridge the gap” in terms of pricing the business, allowing the two sides to find a middle ground, particularly now in the face of an uncertain economic environment.

Two additional benefits are that earnouts allow a transaction to take place with less cash being required up-front. And they also help control potential issues with competition, as the sellers technically are “leaving money on the table.”

Additionally, earnouts keep the sellers engaged in the business, as they now have a clear incentive to help ensure its continued success.

The common types of earnouts are EBITDA, revenue, gross profit and milestone. EBITDA are the most common, while gross profit earnouts are more popular than ever at the moment. The structure of the earnout typically falls into one of three categories:

• Cliff: The earnout is earned when a sales target is exceeded.
• Tiered: The earnout is earned on a sliding scale as EBITDA is viewed through various thresholds.
• Binary: The earnout is earned based on a “random” metric, like whether a certain number of customers are retained or whether a particular drug reaches clinical trials, for instance.

The two primary techniques for valuating earnouts are (1) the Scenario Based Method, which looks at a different scenarios, such as a base case, an optimistic case and a pessimistic case, and (2) the Option Pricing Method (simulation method), which incorporates thousands or even hundreds of thousands of scenarios to determine the value of the earnout. Option Pricing has become more popular this year due to the uncertainty of the COVID-19 business landscape.

In a transaction featuring earnouts, what advantages does the buyer receive? Let’s discuss several ways a buyer benefits from earnouts.

• Less overpayment risk: Transactions conducted just before COVID hit, for example, generally may not have featured earnouts, and these deals may have experienced a higher likelihood of falling apart soon thereafter. This type of risk is mitigated with an earnout.
• Less up-front cash: This is generally a good thing, of course.
• Additional control over sellers: Buyers generally benefit from keeping sellers involved in the business, which helps ensure a smooth transition while increasing the odds of hitting key milestones thereafter.
• On the other hand, the buyer faces some disadvantages, including:
• Additional payment risk: There may be additional payment required even if the company’s performance is poor. This is particularly common with revenue earnouts where revenue is up but EBITDA is down.
• Potential handcuffing: If down the road, the seller has no chance to achieve an earnout, their desire to assist the company may decrease.
• From the seller’s standpoint, the advantages include:
• Potential upside: The ability to share in the upside after the sale of the company is quite attractive to many sellers, particularly if they are confident in the future of the business.
• Helping to close the deal: Sometimes earnouts can be the key to closing a deal.
• Possible tax advantages: Earnouts may lead to tax advantages down the road.

The sellers’ disadvantages include:

• Company may struggle after sale: This, of course, would result in little or no payment for the seller.
• Long-term earnout structures: Earnouts are typically planned for one or two years, but we have found the COVID environment has resulted in an increase in long-term earnouts.
• Earnout disagreements: Oftentimes it is not clear whether an earnout has been achieved. For instance, whether EBITDA is adjusted or unadjusted is one possible area of disagreement.
• “Locked in” with company: Are you willing to commit to the business for a number of years in order to help achieve those earnout requirements? Some sellers may not be.

So, what has the impact of COVID-19 been on earnouts? Well for starters, the number of transactions during COVID-19 in general has decreased significantly. Due diligence has been difficult due to travel and other restrictions and obviously the financial and business worlds are loaded with uncertainty these days.

Nevertheless, as expected, we are beginning to see transactions (and earnouts) resume in high volume as COVID-19 fears begin to dissipate. Generally speaking, more uncertainty in the marketplace results in more earnouts – and we believe that many transactions have simply been delayed, rather than canceled. So we expect to see many earnouts once COVID starts to appear in the rear-view mirror.