M&A: What Are Earn-Outs, and How Do They Work?
An “Earn-out” is commonly used in merger and acquisitions transactions. Essentially, an earn-out is a risk-allocation vehicle, where part of the purchase price of a company is deferred. The earn-out is paid based on the performance of the acquired business over a specific period of time.
The reason earn-outs are used is simple: They can bridge the gap between the seller, who wants the highest possible valuation, and the buyer, who may be willing to pay top dollar, but only if the seller achieves certain performance metrics, usually based on gross revenue, sales revenue, net profit, or EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization).
When valuing a business, most buyers use data from the last fiscal year, while also examining financial statements that reach back three years or more. But what if the seller is well into the financial year at the time of sale, and he’s putting up great numbers, with strong growth? The seller rightfully wants to get rewarded for that performance, which may not be reflected in the last fiscal year’s financial reports. In this case, if the seller requests it, the buyers may also consider pegging the company’s value to the trailing twelve months (TTM) performance, which represents the last twelve months of results prior to the closing.
Ok, let’s look at an example. Let’s say that a seller wants to sell his business in the middle of the fiscal year. But, with sales on an upswing, he wants a valuation credit for the remainder of the budgeted year. Let’s assume this business did $2 million in EBITDA in 2015, and is projected to do $2.3 million in EBITDA in 2016.
Based on a 7x multiple of EBITDA for both periods, the valuation for the 2015 performance would be $14 million. Now, apply the same multiple to the 2016 performance, and the valuation rises to $16.1 million. In this scenario, the buyer agrees to the valuation of $14 million based on 2015 results. The seller is paid $14 million in cash at closing. But the seller doesn’t want to leave any money on the table, since he’s having a good year. So, for the 2016 period, the buyer and seller agree to a $2.1 million earn-out…if the seller achieves $2.3 million in EBITDA for 2016.
When structuring the performance metrics for an earnout, be exceedingly careful. As a seller, you want to use fair financial metrics that you can achieve and operations you control after the initial deal has closed. The buyer is typically interested in one financial target: the bottom line, either net income or EBITDA. No matter what metrics are chosen to peg to the earn-out, what’s really important is that the terms are fully and easily understood, and are perceived as fair from both sides.
From the seller’s standpoint, they need to understand what the buyer will control, post close. At a minimum, the seller needs to protect the resources required to achieve his earn-out targets. If the buyer is going to put overhead allocations or additional costs on the seller’s business, in terms of expenses for selling, general and administrative (SG&A) expenses, then the seller should probably avoid pegging the earn-out to EBITDA.
When determining targets in that scenario, consider tying the earn-out to sales or gross profit dollars instead. If the buyer agrees that no additional SG&A costs will be added to the business—post close and during the earn-out period—then EBITDA can be considered. In any event, a clear understanding of the terms and metrics is essential to keep both sides happy, cooperative, and working together toward
their mutual success.