Valuation and deal structure represent a critical step in executing M&A transactions. Setting realistic expectations between the buyer and seller can improve the chance of getting the deal done.
An earn-out is a risk allocation tool used in M&A transactions whereby a portion of the purchase price is deferred over a specific period of time and payment is contingent upon the achievement of predefined financial and operational goals. Essentially, earn-outs are designed to bridge potential differences in valuation expectations between the buyer and seller. It represents a way to reduce the risk for the acquirer and is normally used when there is a material gap between the buyer’s offer and the seller’s minimum acceptable price.
Depending on the transaction size and complexity, most earn-outs last between 1 and 2 years after closing and normally range from 10% to 30% of the total purchase price. Some of the key parameters affecting earn-outs are:
- Total contingency (%) over purchase price
- Performance metrics: Revenue, EBITDA, net income
- Earn-out formula
- Earn-out period
- Payment schedule
Normally, earn-outs are more popular in industries where there is a high degree of uncertainty in the projected future cash flows. Some of the benefits associated with applying earn-outs in M&A transactions are:
- Risk sharing
- Financing the purchase price
- Buyer and seller alignment
- Performance bonus for key management
Some key issues affecting dealing with earn-outs:
- Agreement on performance metrics: buyers prefer using net income while seller’s prefer revenue as performance metrics
- Selection of appropriate accounting standards to avoid manipulation
- Agreement on earn-out formula and period
- Adjustments to financial results
To make earn-outs successful in M&A transactions, we recommend the following:
- Keep it simple
- Set realistic performance goals
- Provide incentives
- Manage expectations
