With the pandemic continuing to impact businesses all across the U.S., deal structure has recently increased the use of earnouts to bridge differences in buyers’ and sellers’ expectations. A transaction that might not have seen significant variability in its final purchase price prior to COVID-19 may now be experiencing an increase in earnout considerations.
In this on-demand webinar hosted in collaboration with the Association for Corporate Growth (ACG), Brian Francese, Private Equity practice leader and Steven Siefert, Financial and Valuation director discuss M&A earnouts and the impact of COVID-19.
Expand the section(s) below to view the event notes.
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:
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.
The sellers’ disadvantages include:
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.
Given this expected increase in earnouts, Baker Tilly is always available to assist with any valuation services you may require, including earnout consulting, corporate transactions, financial reporting and tax reporting. Please reach out to Brian Francese for more information about earnouts, our valuation services or anything else you need from Baker Tilly’s team of M&A and valuation specialists.