What is an Earnout?
Most businesses which are actively trading and generating a profit are principally valued at a multiple of their maintainable EBITDA (Earnings Before Interest Tax Depreciation and Amortisation).
Historically often the biggest debate between buyer and seller was what the most appropriate multiple to apply.
However, in a post-COVID-19 world, assessing what the underlying maintainable EBITDA is for those businesses affected by the pandemic can often be challenging.
Many businesses were significantly impacted by COVID-19, whether that be positive or negative. Therefore, acquirers are typically presented with a ‘normalised’ (i.e., covid adjusted) EBITDA by the seller’s advisers to use as a basis for the valuation of the target business.
In most cases this normalised position is justified with a number of reasonable assumptions; however, acquirers are understandably nervous about how the trading of the target might play out over the coming months and years. To protect themselves against the risk of a material deterioration in trading buyers are increasingly seeking to use earnouts in their offer structures and, with the current energy crisis, inflation, recruitment, and supply chain issues all currently impacting to increase risk and economic uncertainty, we would expect this trend to continue.
An earnout is a form of consideration that is typically contingent on the future financial performance of the business, with the performance targets and related considerations agreed upon during the negotiation of the transaction process. An earnout structure protects the acquirer if the business underperforms versus expectations and, usually, provides the exiting shareholders with upside consideration should the business overperform.
With an earnout in place, this gives the seller the opportunity to realise an exit at a valuation based on their view of the maintainable EBITDA, whilst accepting the risk that if the business underperforms post transaction, they will realise a lower consideration.
However, earnouts need to be carefully structured to ensure that the competing interests of buyer and seller are balanced. Considerations for both the acquirer and seller would include:
- In transactions with an earnout structure, the seller would typically need to remain in the business to ensure that the performance targets are met. In this scenario, the seller would need to consider whether they are comfortable working for the acquirer and the acquirer considers whether they want the seller to remain in the business.
- Performance targets for the earnout to be achieved need to be realistic and based on criteria that is relatively simple to assess and subject to limited opportunities for manipulation or distortion by either buyer or seller.
- The time period of the earnout is key for both parties:
- An acquirer may have long term strategic plans for the business that may be restricted due to earnout protections negotiated by the seller. Such protections might also constrain the acquirer’s ability to integrate the acquired business to enable them to achieve their longer-term strategic plans
- A seller may be used to being their own boss and therefore working for an employer may have its challenges. In agreeing on an earnout structure often these ‘cultural’ considerations are extremely important and potentially emotive.
In scenarios where earnouts are part of an offer structure, engaging with experienced professional advisers is imperative to ensure that the structure is appropriate and reasonably strikes a balance between both parties from a risk vs reward perspective.
Considering selling or buying a business?
If you are considering selling or buying a business, our corporate finance team is able to advise you not only on the details of earnouts but also on the overall transaction process.
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