Eround 20-30% of private sales include Earn Outs, per Harvard Law. While a popular mechanism to bridge Vendor and Acquirer pricing expectations, it can be challenging to achieve a win-win for both parties when negotiating an Earn Out.
I’ve observed 10 factors that increase the probability of achieving a win-win during 20+ years of M&A.
If you are short for time, here’s the summary:
1. Cash Now (Initial Consideration) is the cake; the Earn Out (Deferred Consideration) should be the cream cheese icing
2. Basis of the Earn Out. Keep it simple. If your business is profitable and going to remain relatively autonomous go with EBITDA (Earnings Before Interest, Tax, Depreciation & Amortisation) as a solid basis for calculating the value of Initial and Deferred Consideration
3. Don’t be greedy about Deferred Consideration. Remember to look at balance when agreeing the multiple you apply to EBITDA for Deferred Consideration. Using a scaled or ratchet approach can work well
4. Keep the Earn Out period short as is practical. 12-24 months is good…much longer can get messier in my experience
5. Make sure the Vendor will pay. Look at a including a guarantee for payment assuming you hit performance targets for Deferred Consideration
6. Autonomy. The more you have the more likely your Earn Out is to work out as you hoped
7. Agree Senior Leadership Team remuneration including bonuses as part of the sale. It’s not just about the Earn Out.
8. Be realistic about Earn Out caps and consider what you can negotiate to avoid set offs for warranties and indemnities
9. Get good tax advice. Ensure Deferred Consideration is capital rather than income, if possible
10. Ensure there is an effective mechanism for Dispute Resolution. Earn Outs can be delicate. You need a good Dispute process in the Sale & Purchase Agreement (SPA)
And for those after a more detailed read on these Earn Out success factors, here goes:
1. Cash Now (Initial Consideration) is the cake; the Earn Out (Deferred Consideration) should be the cream cheese icing
The starting point for a successful Earn Out is balancing vendor ‘cash today’ with sufficiently motivating and achievable ‘cash/rewards tomorrow.’ If you get this balance right, Earn Outs can be a win-win for the Vendor and Acquirer. If you get this wrong a few ugly things typically happen:
- Decisions made to meet short term profit targets or other KPIs that may not be in the medium of long- term interest of the company. Areas that often take a hit are investment in innovation / R&D, strategic staff hires, staff rewards, training, marketing and the ability to commit to continuous improvement.
- Lack of senior staff alignment to objectives. Those senior leaders who benefit from the Earn Out may be focused on different priorities from those who are not shareholders or had share options at the point of exit. In other words, personal objectives could conflict with company objectives.
- Distraction from sub-optimal relationship with the new parent. Irrespective of whether the company post acquisition is autonomous (more on that later) or integrated into the Acquirer’s group, both parties need to be in tune about what’s best for the business. An out of balance Earn Out ‘cash tomorrow’ element can make that very difficult to achieve.
2. Basis of the Earn Out. Keep it simple
Top line measures are popular such as revenue, gross profit and assets under management. However, if the business is profitable and going to be relatively autonomous, EBITDA is a solid basis for Deferred Consideration.
Around 25% of Earn Outs use EBITDA because it’s the closest approximation to cash readily available, which strips out the implication of how the balance sheet is structured in terms of debt and investment in tangible and intangible assets. It’s not perfect e.g. if a business chooses operating leases rather than say, finance leases to fund material capital needs, then EBITDA will be lower.
Like I said, it’s not perfect but EBITDA and EBITDA multiples are tracked by the Stock Exchanges for a reason – it’s as close to cash you can get.
3. Don’t be greedy about Deferred Consideration.
There’s a few ways you can slice and dice this. You can apply:
A. The same multiple to EBITDA for the Initial and the Deferred Consideration
B. A different multiple to EBITDA for the Initial and the Deferred consideration
C. A specific multiple to EBITDA for the Initial Consideration and a scaled or ratchet multiple for Deferred Consideration
This is one of those where there’s lots of room to negotiate. Option C can be very good to balance the needs of the Vendor and the Acquirer. It does take some finesse though to agree the ratchets. Always keep top of mind that, the Earn Out should be the icing, not the cake…
4. Keep the Earn Out period short as is practical.
Shorter is better and I’d suggest 12-24 months. Please bear in mind any major milestones that could cause a significant revenue/profit uplift, which may require a different time-frame. In my experience, longer Earn Outs tend to be messier, as it defers fully embedding the business into the Acquirer, if the business is not to remain autonomous.
5. Make sure the Vendor will pay
This is another key negotiation point – agreeing some form of guarantee to underpin payment of the Deferred consideration. If they don’t want to provide a guarantee assuming the KPIs are met, then ask yourself why not?
6. Autonomy.
This is the tricky part of the day to day reality of Earn Outs.
Consider:
- Synergies from working together
- Possible head office cost allocations from Acquirer
- Investment parameters and how they are treated in the calculation of EBITDA
- Investment parameters and how they tie into EBITDA achievement. Bear in mind that if you have milestones that trigger investment, this can cause the Earn Out to be scuppered early on. E.g. if you don’t hit A then it could be unlikely you’d get the investment to hit EBITDA B by time C etc
- Partnering on opportunities – agreeing revenue and cost splits
- A moratorium on the transfer of selected business to elsewhere in the Vendor’s Group or material changes in the business during the Earn Out period without the Vendor’s reasonable consent
- Goods and services purchased by the Vendor to be for the benefit of the Vendor’s business unless the Vendor consents otherwise (being reasonable)
7. Agree Senior Leadership Team (SLT) remuneration as part of the sale
Forecast EBITDA needs to ensure the SLT maintains and grows their current levels of remuneration with appropriate incentives at a personal level, irrespective of the Earn Out process. This helps to maintain and grow a cohesive SLT post acquisition and minimising the Earn Out ‘cash tomorrow’ distraction factor.
8. Be realistic about Earn Out caps
Consider what happens if you over-achieve! At the same time – remember that the Earn Out should be the icing, not the cake.
Further be careful of the Vendor’s wanting to use the Earn Out for set off against warranty and indemnity claims. This is a popular feature of Earn Outs but should be carefully handled so that the Earn Out is still attractive (assuming it’s the icing and not the cake).
9. Get good tax advice
Depending on where your company is based, tax laws will vary. Irrespective, it’s key to understand what would trigger the Deferred Consideration being treated as income rather than capital for tax purposes, to ensure the deal is tax effective.
10. Ensure there is an effective mechanism for Dispute Resolution
Earn Outs need to perform a balancing act, as control of the Vendor’s company transitions to the Acquirer. Not surprisingly, this can cause issues, so it’s vital to have a practical Dispute Resolution process in place as part of the SPA. Typically, I prefer good faith negotiation, then mediation and if unavoidable, arbitration. The latter can be very time consuming and expensive – so avoid it if possible.
In summary
Keep the Earn Out as simple as possible and most importantly, make sure it’s the icing and not the cake.
Earn Outs are utilised in 20-30% of private sales.
So are you considering them as part of your Exit? And if you are, how Exit Ready is your business is today?
Otherwise, I look forward to your feedback on the 10 Earn Out success factors.