Earn-outs in M&A Transactions

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

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