If you’re buying, there’s a component well worth factoring into the deal: The earnout.
Private equity firms are structuring earnouts in 43% of their transactions – the highest proportion since 2012, according to the Pitchbook Global PE Deal Multiples & Trends Report. And at my former employer, we included earnouts as part of the total consideration in every single transaction we did – with only one exception.
Why are earnouts so popular – and so valuable — to the buyer?
One reason why to pursue an earnout is that it allows the buyer to defer part – or all – of the purchase price and tie it to the performance of the seller’s business. Two, an earnout protects the buyer from overpaying for the business. Simply, if the seller doesn’t perform under the earnout structure, the seller does not get paid. Third, with seller valuations increasing in the last 24 months, an earnout is a great a way to create a “win- win” for both parties.
Structuring the earnout
An earnout can be structured a number of different ways depending on the desires of the buyer (e.g., grow a certain area of the business, improve the P&L). The earnout can be based off of revenue growth, gross margin, operating margin, or net income.
The future earnings component of the earnout protects the buyer if the seller has struggled a bit historically and is now projecting aggressive numbers going forward. Simply: The earnout provides a “put up or shut up” structure.
For example, suppose a seller’s earnings are $500,000 and it’s asking for a seven multiple of those earnings ($3.5 million). The $500,000 in earnings might be the seller’s best year ever (everyone wants to sell on a high and not on a low).
The question of course for the buyer is: Will this trend continue based on only one year of top performance to show?
This is where the earnout comes into play, especially if the seller is confident it can continue to hit those numbers and do even better.
In this example, in figuring out how to pay the seller seven times its earnings ($500,000), the buyer could structure and negotiate the deal as follows:
- Pay 50% or $1.75 million in cash up front.
- Pay the remaining $1.75 million by giving the seller 50% of every dollar earned above $500,000 (which is called the threshold) up to the $1.75 million.
Since the buyer is already paying a multiple of “upfront” consideration in cash at closing, the $500,000 becomes the threshold and the buyer keeps those earnings moving forward. In this example, the buyer would pay 50 cents on the dollar above the threshold capped at $1.75 million.
This is just one example of how an earnout can be structured. Some buyers choose to not cap the earnout since they consider everything above the threshold to be a “win-win.” In any deal, negotiations can take place and adjustments can be made to get the seller what it wants or deserves while ensuring the buyer does not overpay or give the seller everything up front.
If you’re the buyer in a transaction, a skilled M&A advisor can help you evaluate your earnout potential, and make sure you don’t pay too much too soon. It’s an option well worth exploring.
Steve Pomeroy is the founder of Big Change Advisors, a unique M&A consulting firm in Los Angeles that helps businesses achieve big goals while making a big impact on society. To request a free consultation, contact us.
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