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Structuring Earnouts in M&A: Key Strategies, Metrics, and Negotiation Tips
4 minute read
Written By Nikoleta Exis
Key Points
Here are the key points from a recently released article from Axial that explores structured earnouts and the data compiled from 50 M&A transactions.
- Earnouts allow part of the purchase price in M&A to be contingent on future performance, balancing buyer risk and seller potential gain.
- Common earnout metrics include EBITDA, revenue, and gross profit, tailored to the specifics of each deal.
- Earnouts help align interests but can lead to disputes over management and payout calculations during the earnout period.
- Properly structuring earnouts with clear terms and dispute resolution mechanisms is essential to avoid conflicts.
- Legal and financial advisors play a critical role in ensuring earnout agreements are fair, enforceable, and beneficial to both parties.
Summary
Axial recently published an insightful article showcasing key data from 50 M&A transactions. This piece aims to summarize and highlight the most critical information you need regarding their compiled data and the structuring of earnouts.
Earnouts are a common mechanism in mergers and acquisitions (M&A) that allow part of the purchase price to be contingent on the future performance of the acquired business. This payment structure is typically used when the buyer and seller have differing views on the company’s valuation or when there are uncertainties regarding future revenue or profit generation.
Earnouts serve as a bridge between buyers and sellers by aligning the incentives of both parties. The buyer mitigates risk by deferring part of the payment, while the seller has the opportunity to receive a higher payout if the business performs well post-acquisition.
There are multiple ways to structure earnouts, with the specifics depending on the industry, the size of the deal, and the overall goals of both parties involved. Common metrics used to calculate earnout payments include earnings before interest, taxes, depreciation, and amortization (EBITDA), revenue, or gross profit. It is important to clearly define these metrics and any potential adjustments to avoid future disputes.
Deal Size vs. Earnout Percentage
One variable that may affect earnout percentage is deal size. From the data compiled, it seems as though there is a slight inverse correlation between total deal size and their earnout percentage. Smaller deals tend to have a higher percentage of their total enterprise value (TEV) allocated to earnouts compared to larger ones. One possible factor that may be causing this inverse relationship is that those buying or investing in the lower deal sizes may have less capital at the closing.
Another reason for the relationship could be the perceived risk associated with smaller businesses. Buyers may view larger deals as more stable and established, leading them to rely less on performance-based payouts. In contrast, for smaller businesses, buyers might be more cautious due to uncertainties about future performance, prompting them to structure earnouts as a way to mitigate risk and align incentives with the seller’s ongoing performance.
Negotiating an earnout can be complex, requiring careful consideration of various factors such as the length of the earnout period, the level of control retained by the seller, and protections against financial manipulations by either party. Both legal and financial advisors play crucial roles in ensuring that the earnout is fair and enforceable.
Despite their benefits, earnouts can present challenges. There is often a tension between the buyer’s desire to minimize payouts and the seller’s goal of maximizing the performance of the business. Furthermore, disagreements may arise over how the business should be managed during the earnout period. A well-drafted agreement can help mitigate these risks by providing clear guidelines and mechanisms for dispute resolution.
Conclusion
Earnouts are a valuable tool in M&A transactions to address valuation differences and performance uncertainties, offering benefits to both buyers and sellers. However, their complexity means that clear structuring, transparent terms, and effective dispute resolution mechanisms are essential. Having an experienced M&A broker involved in the process can be crucial in navigating these complexities. A skilled broker helps ensure both parties’ interests are protected, provides valuable insight during negotiations, and structures the earnout in a way that maximizes the potential for a successful transaction. With the right guidance, buyers and sellers can leverage earnouts to achieve favorable outcomes while minimizing risks.
Questions This Article Answers
- How are earnouts structured in mergers and acquisitions?
- What are the common metrics used in earnout agreements?
- What are the risks and challenges of using earnouts in acquisitions?
- How does an earnout affect the sale price in M&A deals?
- What is the best way to negotiate an earnout in an acquisition?