OpinionEarn-outs: bridges leading to an exit
Earn-outs: bridges leading to an exit
“Earn-outs, the legal jargon for conditioning and deferring part of the purchase price in an exit on the achievement of certain agreed milestones, are an established tool for compromising on the valuation of a company,” writes Adv. Ariella Dreyfuss, partner in the Corporate and M&A Department of Barnea Jaffa Lande
No one likes to overpay. No one likes to leave money on the table.
In the current market, where cheap financing has been replaced by rising interest rates, fears of recession linger, and tech valuations are being reassessed, earn-outs can help bridge the divide between how much purchasers are willing to pay and how much sellers are willing to accept in an exit.
Earn-outs, the legal jargon for conditioning and deferring part of the purchase price in an exit on the achievement of certain agreed milestones, are an established tool for compromising on the valuation of a company, by tying a portion of the price to the post-closing results, financial or otherwise, of an acquired business.
Earn-outs are traditionally used by purchasers for a variety of reasons. Predominantly, they allow the purchaser to hedge its bets by agreeing to pay the disputed part of the target’s valuation only if and when the sellers’ arguments about the business’ valuation are validated. They allow the purchaser to manage its cash flow by deferring part of the payment to a later date, and if the agreed metrics are financial (i.e., based on EBITDA, revenues, or profits), they allow the purchaser to potentially pay the deferred portion out of the future results of the business, rather than out of its own pocket or by securing external financing. Earn-outs also provide purchasers a retention tool to incentivize sellers to stay on as management to facilitate a successful transition and integration of the target business.
For sellers, earn-outs simply provide an opportunity to improve their exit when their projections for the business materialize.
Earn-outs are often employed when the purchase price is calculated on the basis of the potential growth of the company or when the business is new and not supported by financial data. Such factors are often true for Israeli startups, they may have developed a great piece of tech, but have limited revenues or operating history, or have yet to enter promising new verticals and geographic markets, or for Israeli medtech companies, they may await FDA approval or qualification for insurance reimbursement, on which their promise and value depends.
Unsurprisingly, as a result of the challenges Covid-19 posed to valuing targets, either because the businesses were enjoying potentially temporary success (for example online retail) or suffering a potentially temporary downturn (for example the hospitality sector), we have seen an uptick in the use of earn outs.
Naturally, in highly competitive tender bids, earn-outs may not be a suitable tool. However, with cheap money now a memory, coupled with caution due to the state of the economy, there are fewer players looking to make acquisitions, leading to a shift from a seller’s to a buyer’s market. The expectation is that, emboldened by the knowledge that competition is sparse, acquirers will insist and earn-outs will become more prevalent, and the percentage of the overall portion of the purchase price being held back will increase from the current 30% mark.
But sellers should advance with caution, as the road to achieving prized earn-out targets is likely to be peppered with potholes. To sidestep these, the milestones should be clear and objective, the earn-out periods realistic and not too ambitious, the payments pro-rata, and the payment schedule frequent, rather than a bullet all-or-nothing arrangement.
But the biggest pothole for sellers to dodge is the purchaser’s control over the business post-closing. The seller needs to ensure that during the earn-out period it has the budget, manpower, and freedom to run the business in a manner that it can attain the agreed targets, and the purchaser cannot frustrate or circumvent it. Here there is always tension, as the interests of the buyer and the sellers are not always aligned.
The sellers may be driven solely by the earn-out, monomaniacally pursuing targets at the expense of the general health of the company. For example, if the metrics are based on the volume of new customers, they may offer loss-making discounts. The buyer, on the other hand, desires the freedom to run its newly acquired business at its discretion, and, particularly in a strategic acquisition, to integrate it efficiently into its existing business, while looking out for the general profitability of the company and the corporate group.
As a result, earn-out negotiations are fraught with discussions over control of the business, availability of resources, applicable accounting principles, acceleration of payment if key employees leave or if the company/acquirer goes public or sells the business, comfort for the sellers that the buyer is good for the money - particularly if the metrics are not financial, information and audit rights, and whether the earn-out amounts can be set off against any indemnity or other claims.
Earn-outs are certainly not the perfect solution, and it is arguably preferable to compromise on price in favour of certainty and a clean break, rather than to hold on to the promise of a potential pay-out, while simply postponing the dispute over the final price to a future date.
However, in todays’ market, earn-outs may be a very useful tool to provide the buyer comfort that it is not overpaying or over extending itself, and the sellers’ comfort that they have not left money on the table, or to use the Israeli vernacular, that neither have been a “frayer”.
Adv. Ariella Dreyfuss, is a partner in the Corporate and M&A Department of Barnea Jaffa Lande