Turning to Earn-Outs

Turning to Earn-Outs

A potential solution for negotiation stalemates

Sometimes merger and acquisition negotiations reach an impasse — even when both parties are committed to making the deal succeed. When buyers and sellers are at loggerheads over pricing, all of the transaction’s benefits can fall to the wayside.

There may, however, be an alternative: an earn-out. With an earn-out agreement, the buyer agrees to make periodic payments to the seller if the company meets specific performance goals. In some cases the seller may choose to stay with the company to be able to influence its results after it has been sold.

INCENTIVES FOR EVERYONE

An earn-out can be a particularly effective way to bridge the gap when the buyer and seller disagree about the value of the company. The promise of future payments can assuage seller concerns that they’re settling for a price that undervalues their business. And, assuming the seller continues to work in the business, earn-outs help reassure the buyer that the seller will work hard to maintain the company’s performance. In many cases earn-outs are more effective, and easier to measure, when the selling company continues to operate as a stand-alone subsidiary or the seller continues to manage it as a division of the acquiring company. If a target is intended to be immediately absorbed by the buyer, earn-outs may not make sense unless they are tied to top line revenue because sellers will have little or no control over the newly merged company’s profitability.

NEGOTIATING THE DETAILS

Although earn-outs often provide a solution to difficult price negotiations, the process of agreeing on an earn-out structure can prove challenging as well. The parties need to discuss the form that seller payments will take as early as possible, because this decision can have other ramifications. If, for example, a seller wants to be paid in stock, the parties must decide whether the stock will be valued as of the deal closing date, at some other date, or by another measure.

The parties also must agree on the objectives that must be reached to trigger earn-out payments and an acceptable accounting method, typically Generally Accepted Accounting Principles (GAAP) by which to measure achievement of these objectives.

Earn-out objectives could include:

Sales – Often, sellers prefer that performance be measured by gross sales, because they provide a clear and easily measured goal that management can directly influence. The parties may agree to set annual or quarterly performance thresholds based on revenues.

Earnings – If performance is measured by EBITDA (earnings before interest, taxes, depreciation and amortization), the seller will need to show that it’s achieving a certain level of pre-tax cash flow. Earn-out payments typically are a percentage or multiple of the amount by which the seller division’s results exceed a set EBITDA figure.

Non-financial – In some earn-outs, payments are based on non-financial goals specific to the industry or business. A software company, for example, may be required to successfully roll out a new product that is only in the development stage. Or a pharmaceutical company may need to obtain FDA approval to market a new drug.

DON’T FORGET EXEMPTIONS

Sellers typically request protections to ensure earn-out payments regardless of the buyer’s financial condition at the time they are due. Buyers, on the other hand, generally try to include language in the agreement that subordinates earn-out payments to other obligations, such as outstanding loans.

Sometimes circumstances make it difficult for sellers to meet earn-out goals. For sellers, therefore, it’s crucial to negotiate earn-out exemptions. Sellers generally push for a widespread set of exemptions to ensure that, for example, future capital expenditures or the introduction of competing product lines doesn’t erode their ability to achieve earn-out goals.

For their part, buyers usually try to ensure the selling company’s owners and executives don’t maximize short-term goals at the cost of long-term profitability. For example, a seller might focus on selling large volumes of existing products while neglecting new product development.

But parties can bridge such differences in interests. A buyer might retain the right to take actions that could affect the seller division’s sales or profits, but the financial impact of those actions will be excluded from the seller’s earn-out calculations.

DIFFICULT BUT FAIR

Failure to agree on price is one of the most common M&A deal-breakers. Earn-outs can introduce flexibility to a negotiation stalemate. The key to success is to ensure that both parties walk away from the table feeling they have achieved their most important goals.