The Future of deal structuring post Covid-19: The Earnout

When we finally begin to approach the end, or the beginning of the end, of this extraordinary period in our lives, many business people’s attention will return to either growth strategies or exit strategies, dependent on where they, (and their business’), are in the “life cycle”.

One effective way to achieve growth, or exit, is a business acquisition/sale.

But, the current situation has created a real problem. How do you value a business in this climate?

A seller will likely argue a business should be valued on its performance prior to the introduction of lockdown; a buyer will likely argue that you can’t guarantee it will return to that level of turnover/profit and therefore a (major) discount should be applied. Or should there just be no deal?

Not necessarily…

Disagreements about a business’s valuation are nothing new, it is just that we have a new set of circumstances to apply to the problem. One tried and tested way to bridge this gap of expectation is to introduce an earnout into the deal.  An earnout can bridge the gap between an optimistic seller and a sceptical buyer.

As we move back to whatever “normal” turns out to be it’s probable that earnouts will become far more prevalent than in more recent years.

So what is an earnout?

In simple terms an earnout is a risk allocation mechanism which makes the purchase price contingent on the “future performance” of the target business.

The acquirer pays a proportion of the purchase price upfront, and the remainder is contingent on the performance of the target business.

There can be an overall cap and floor to the total purchase price, or it can be entirely contingent on future performance. Which option is taken will depend on the sector the business operates in and the appetite for risk of the parties.

Structuring of the earnout wording is vital - and each party should fully understand the often complex mechanisms. Amongst a number of matrices will be how the business operates, who will have what kind of control over the business and what can be changed in the earnout period?

Earnout mechanisms can range from the simple to the very complex but a few considerations for structuring them are:

Control –  the seller will often be required, and in many cases will wish, to remain within the business for the earnout period, to control it or at least be on hand to manage or observe key decisions and metrics. If the seller is to leave and not be there for the earnout period then detailed criteria will have to be agreed as to what the buyer can and can’t do with the business in the earnout period. This is often referred to as a freeze box.

Financial Metrics – these will include revenue, EBITDA, net income, and earnings per share. For obvious reasons, sellers seek to base the earnouts on revenue, which is difficult for the buyer to manipulate but easy to achieve. Equally, a buyer will not want the sellers to take up projects with low margins just for the sake of revenue. Therefore, the buyers will usually seek to achieve a combination of revenue and margins for earnouts.

Key employees - depending on the type of business it is, it can be very important for the seller to include key employees in his/her plan as they can be a key resource to drive revenue and achieve projected EBITDA margins. For the buyer they can be a vital requirement of the deal as key employees can often own important client relationships and/or have a better understanding of certain aspects of the business than the seller themselves.

Length of the earnout period – for understandable reasons the seller may not be keen to work for very long within the business he used to own under rules laid down by the buyer and will want to avoid possible clashes of style or culture. Owner, managers/founders and corporates may not be easy bedfellows. Therefore, it is good practice to keep the earnout period as short as possible to achieve the overall aim, but both the buyer and the seller have to be mindful of outside influences in agreeing how long is short enough.

What is vital in any negotiation of the earnout mechanisms and periods is that both the seller and buyer have competent and experienced legal and financial advisors at their side. In an earnout – the devil is absolutely in the detail.

At BPE, we are here to help and will carry on delivering the legal support you need, in what is unquestionably a challenging time.

Please do not hesitate to contact myself or one of the wider team if required.

These notes have been prepared for the purpose of an article only. They should not be regarded as a substitute for taking legal advice.