Bridging the Valuation Gap with An Earn Out

 

 

There is an old saying in M&A: “The money you see at settlement is all the money you are ever going to see.”  So why do people agree to earn outs – mechanisms where 15%-30% of the purchase price is paid over time after settlement depending on whether certain KPIs are reached?

 

Earn Outs as a Way of Bridging the Valuation Gap in Business Exits

 

The answer is that parties rarely agree on a valuation of a business.  In a $20m deal, if you are a million dollars apart and you have no other buyer, what do you do?  Walk away?  Logic has it that you should at least try to come to some sort of agreement.  Take $19m now, and agree for the final $1m to be paid later if the target achieves certain targets after settlement.  This is the classic earn out.

  • An earn out is a mechanism where part of the purchase price is payable after settlement, contingent on the results of the target during the earn out period. 

The real issue is that there are two informational environments:

  • One where one party (usually the seller) has more information about the target deal value (“private information setting”) where that party thinks the target is worth more (or sometimes less),and
  • One where the parties simply disagree on the valuation of the target (“non-convergent priors setting”).

An earn out is a way of conditioning payment on verifiable information that is available to both parties after settlement that solves the problems of private information or non-convergent priors.

The earn out is different to post purchase price adjustment where valuation is basically agreed, but there are uncertainties over things like the net working capital or shareholders’ equity or stock in trade that can be calculated shortly after settlement.

 

An earn out, by contrast, is where the parties agree on post-settlement KPIs such as EBITDA, net income, or revenue and then the amount that the vendors receive after settlement depends on whether these targets are met.  The earn out period is usually between one and three years and can represent between 15%-30% of the deal consideration.  Generally speaking, the lower the earn out, the better the negotiation position of the vendor (though sometimes this could indicate that the deal was mispriced from the vendor’s point of view).

 

The earn out is a mechanism for rewarding the seller if the seller’s projections prove accurate.  Equally, the earn out protects the buyer if those projections do not prove accurate.  They are a useful way to bridge the valuation gap when:

  • The target has a limited operating history but bright prospects,
  • Has had flat or decreasing earnings but a new revenue stream that has not yet proved itself, or
  • Is asset light and the buyer is therefore not able to obtain all the financing required to buy it out.

Advantages of Earn Outs to Buyers


In addition to providing a way of meeting the seller on price, the earn out can reduce the risk of overpaying for an asset by withholding future payments if the asset does not perform as expected.  It also serves as financing mechanism because it reduces the amount payable upfront.  Importantly, it allows the buyer to finance the acquisition out of future earnings of the company it just bought.

 

Where the vendors are also managers of the target company, earn outs keep them employed there for between one and three years on average, and they have the effect of aligning the interests of the vendors and the purchasers of the target.  The vendors want the company to do well so that they can get their final payments and the purchasers want the business to do well so that their investment is justified.

 

Earn outs are also valuable for the buyer in providing security for breach of warranties and indemnities in the sale and purchase agreement:

  • A warranty is a statement of fact about the business or company made by the vendor.  If it is not true, the purchaser can sue and get damages that would put the purchaser in the position it would have been if the warranty were true (subject to the usual rules about mitigating your loss and remoteness of damage).
  • An indemnity, on the other hand, is a promise to reimburse the purchaser if it suffers a loss (which is not usually subject to the requirement that the purchaser mitigates its loss).

If you had to come up with a rule of thumb about the difference between the two, it would be that:

  •  Warranties protects the purchaser from unknown liabilities, and
  • Indemnities protect the purchaser from known liabilities.

So when it comes to actually paying out on a warranty or an indemnity claim, if the buyer is holding back money anyway, it can simply deduct it from the amount to be paid under the earn out.

 

Advantages of Earn Outs to Sellers


The main advantage of the earn out to the seller is that it increases the chances of actually selling the company or business.  This is especially true when there are no other buyers. Ideally, the amount the seller receives at settlement is all the money the seller wants, and the earn out is a bonus.

Another advantage to the seller is when the seller knows the upside in the business but is unable to articulate it to the buyer or is unable to convince the buyer that it will happen.  In this case, the seller gets a better price than it would on a fixed price transaction.

 

The other advantage is that the seller can “take some money off the table” today whilst still participating in part of the upside of the company after the sale.

 

Disadvantages of Earn Outs to Both Buyers and Sellers


The main difficulty is the time it takes to negotiate and draft a decent earn out that satisfies both parties.  This task usually falls to the corporate advisor or investment banker during the negotiations and involves lengthy discussions with management to determine how it is going to be calculated. 

 

Then the lawyers need to draft clauses that accurately reflect that intention and that work well into the future when the circumstances of the business, the seller and the buyer might be entirely different.

 

Then there is the difficulty of the divergent interests of the buyer and the seller – the buyer has some interest in the business not performing so it doesn’t have to pay out more, whilst the seller has an interest in short term business decisions that boost the KPI used to calculate the earn out (for example, if the earn out is based on EBITDA over three years, the seller is not particularly interested in depressing EBITDA with investment that ensure explosive growth in the business in five years time).

 

So this and other tensions in the alignment of the buyer and seller gives more potential for disputes in the future about the earn out.

 

The other disadvantage is that the sellers have to work in the business they just sold for up to three years.  Many entrepreneurial owners find it difficult to work for someone else, particularly if they have sold to a much bigger company that has very defined systems and procedures that may seem stifling.

 

Conclusion


If you can’t agree on valuation (and you probably won’t), then you should consider an earn out as a way of bridging the valuation gap.  It can, however, mean a lot of work for that last 15%-30% and there are risks that you might not get it.  In our next post, we will go into earn outs in greater detail so you can decide which way to jump.

 

Disclaimer: I shouldn’t really have to write a disclaimer here about using this as legal advice as I am sure you are smart enough to work out that it is general commentary only and it may not suit your own personal circumstances.

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