Structuring Earnouts: Data Insights from 50 M&A Transactions

Both earnout transaction volume and number of deals are peaking, particularly as a percent of total M&A activity. An earn-out structure might not be the best path if the seller wishes to completely disconnect from the business immediately after sale, as earn-outs often require their ongoing involvement. They should also be avoided in deals where future performance is unpredictable or not within the seller’s control. Earn-out payments are typically calculated based on performance metrics agreed upon in the M&A contract.

How is an earnout structured?

Their purpose is to bridge valuation gaps between both parties and ensure additional compensation is paid if a business achieves predetermined financial targets after it’s sold. The court found that language comparing efforts to those “typically used by biopharmaceutical companies” and “typically considered by biopharmaceutical companies” in earnout data from m&a deals the CRE definition meant that Alexion’s efforts should be measured against an abstract and aggregated industry standard. While at SRS Acquiom, Casey has represented shareholders’ interests on hundreds of deals, including defending claims up to $400 million and administering life sciences deals with as much as $1 billion in contingent consideration. An earnout is a clause in a contract that provides for additional compensation to selling parties if certain performance targets are hit. Earnouts are particularly common when a business is at a growth stage or relies on unproven products and markets.

• On the other hand, buyers may seek control over certain business decisions as they are eager to execute their vision.
• This is likely to give rise to disagreements over the interpretation of performance metrics as achieving earnout targets may be influenced by factors beyond the seller’s control.
• When a private market M&A transaction occurs, it may seem that the buyer and seller of the target company easily agree on the business’s valuation.
• J&J was specifically prohibited from taking into account the cost of any earnout payment, and the merger agreement did not specify that J&J had complete discretion over decisions relating to the acquired business.
• There may also be instances in which either the buyer or seller breaches the earnout contract by failing to comply with requirements.
• Therefore, a combination of metrics, such as profit and revenue, are often used to balance out the interests of both parties.

It is important to clearly define these metrics and any potential adjustments to avoid future disputes. Advantages of earn-outs include providing a flexible payment structure and aligning the interests of buyers and sellers post-transaction. They can make deals more attainable by bridging valuation gaps and offer sellers the opportunity to benefit from future growth.

The Role of Earnouts in Bridging Valuation Gaps

He leverages his extensive expertise and SRS Acquiom proprietary data to produce resourceful content regularly utilized by market practitioners. Implementing earnouts effectively requires careful planning and execution to ensure smooth integration and mutual satisfaction. Another illustration could be a manufacturing business that based its earn-out on gross margin improvement, which incentivized cost-saving initiatives without sacrificing product quality. It’s these kinds of examples that provide a blueprint for others to follow, showcasing how a thoughtful approach to earn-out structuring can turn potential conflict into collaboration.

When it comes to earnouts, integration and collaboration can be some of its greatest challengings. Buyers who underestimate the importance of implementing both successful integration and strengthening collaborative efforts during an earnout could miss out on the true value that these types of transactions bring. One of the most common challenges is determining and setting unambiguous performance metrics which need to be met for the aggrieved party to receive their contractual consideration. Ultimately, all parties involved in M&A should approach earnouts with great care and consideration and ensure detailed documentation is in place to mitigate potential conflicts and disputes. An earnout is structured in this way because company performance is linked to management and other senior figures in the organization.

Help M&A run smoothly with earnouts

Think of these triggers as the milestones or goals which, when met, release funds to the seller. Each payment is akin to hitting a checkpoint in a video game; achieve the specified performance metrics within the earn-out period, and you unlock the next part of your financial reward. Navigating earnouts in mergers and acquisitions requires considerable care and planning to ensure that both parties can benefit from the arrangement. Merging entities can leverage the potential for higher valuations made possible with a well-structured, risk-mitigating earnout. By tying future payment obligations or risks to specific performance metrics, both parties can be confident that expected outcomes will be addressed fairly.

The report provides analyses of earnouts and indemnification claims from more than 850 private-target acquisitions, valued at approximately $168 billion, for which SRS Acquiom served as shareholder representative. All deals examined in the report included escrows that were fully released between Q and Q2 2024—including 518 individual indemnification claims and 200 earnout milestones. Most of the data featured in the report is not publicly available and is not available anywhere else. An earnout agreement must include several vital clauses to safeguard the interests of both buyers and sellers. These clauses define the structure and enforceability of the earnout and help prevent misunderstandings or disputes. Earn-out disputes can become the thorn in the side of what otherwise seems like a rosy transaction.

This is likely to give rise to disagreements over the interpretation of performance metrics as achieving earnout targets may be influenced by factors beyond the seller’s control. Therefore, a combination of metrics, such as profit and revenue, are often used to balance out the interests of both parties. When uncertainty exists about the future performance and revenue potential of an acquired business, the buyer and seller may include an earnout in the transaction. Earnouts are commonly based on the business meeting revenue targets, profit margins, or other key performance indicators after the sale is complete. There are multiple ways to structure earnouts, with the specifics depending on the industry, the size of the deal, and the overall goals of both parties involved. Common metrics used to calculate earnout payments include earnings before interest, taxes, depreciation, and amortization (EBITDA), revenue, or gross profit.

• Ensure that you have consensus on the scope of authority for the seller too – they should have a fair degree of control over the ability to meet the earn-out targets without undue interference.
• However, the court found that J&J’s efforts toward the Monarch platform regulatory milestones, even though they were flawed and may have prompted unintended delays, were not commercially unreasonable.
• Be clear about the level of operational control necessary to steer the company towards achieving the earn-out goals without meddling too much in day-to-day operations.
• Factors like historical earnings, growth potential, industry standards, and the unique characteristics of the business itself play into shaping the earnout structure.
• The volume and number of deals using earnouts in the past five years dwarfed the previous five, the data shows.

An “earnout” is a contractual mechanism in a merger or acquisition agreement, which provides for contingent additional payments from a buyer of a company to the seller’s shareholders. Earnouts are typically “earned” if the business acquired meets certain financial or other milestones after the acquisition is closed. Indeed, with careful planning ahead of time, earnouts help create relationships with lower long term risks mitigating exposure on both sides of any deal between buyers and sellers within mergers and acquisitions. And sellers in particular should be watchful for any unorthodox application of accounting principles so that (for instance) the business’s earnings for a given financial period miss the agreed milestone for earnout payments. It may be advisable for the SPA to explicitly stipulate adherence to generally accepted accounting principles (GAAP) methods, or international financial reporting standards (IFRS), to mitigate risk here. For sellers approaching an earn-out, key tips include pushing for realistic targets, understanding the timeframe for achieving them, and ensuring the right to be involved in decisions that might impact the business’s performance.

Essential Tips for Sellers and Buyers

From purchase price to performance metrics, here’s how to structure an effective earnout. It is important to document the detailed interpretation of metrics, discuss the potential areas of disputes upfront, and establish a framework that accommodates the interests of both buyer and seller. By doing so, the earnout arrangement can become a harmonious collaboration rather than a potential source of conflict. Staggered payments occur when the seller’s shareholding is offloaded in tranches over time.

Importantly, the agreement should outline how these metrics are measured, verified, and reported, particularly as the conditions are increasingly complex. Parties need to agree on the amount of the earnout, its criteria, and the specific definitions of particular milestones. Outside of clinical trial outcomes, other external earnout metrics can include successful contract renewals or new product launches, while internal (often financial) metrics may be tied to the achievement of certain EBITDA or revenue thresholds. An earnout allows the buyer of the target company to delay a portion of its payment until certain conditions are met at some point after the transaction closes.

You can leverage this to get more money upfront from the buyer instead of having to ‘earn it out’ over the next few months. There is often a tension between the buyer’s desire to minimize payouts and the seller’s goal of maximizing the performance of the business. Furthermore, disagreements may arise over how the business should be managed during the earnout period. A well-drafted agreement can help mitigate these risks by providing clear guidelines and mechanisms for dispute resolution.

Now that the basics are out of the way, we can move on to constructing an earnout arrangement beneficial for both sides, much like piecing together a jigsaw puzzle with its components symbolizing the vital interests of each party involved. However, the buyer would likely be skeptical about your growth forecasts and does not believe the company will do as well as you imagine. The payout will appear in Cash Flow from Financing and reduce cash flow and the company’s cash balance. Income taxes are invariably significantly higher than capital gains taxes, so it is in the seller’s interest to ensure everything is clearly laid out in the SPA. To learn more, read the interpretation of His Majesty’s Revenue and Customs (HMRC), the UK’s tax authority, here.

The court further held that the accountant did not exceed its scope of authority when it resolved certain factual disputes connected to the earnout dispute. A well-structured earnout starts with a clear alignment between the buyer and seller on the performance targets and reporting methods to measure success. Beyond the basic components of an earnout, these agreements should include additional covenants detailing who has decision-making authority over the business and how to resolve disputes.

This article provides high-level information on what you need to know about M&A earnout provisions to make informed decisions and maximize the opportunity for a successful M&A transaction. Earnouts are a common mechanism in mergers and acquisitions (M&A) that allow part of the purchase price to be contingent on the future performance of the acquired business. This payment structure is typically used when the buyer and seller have differing views on the company’s valuation or when there are uncertainties regarding future revenue or profit generation. Earnouts are a valuable tool in M&A transactions to address valuation differences and performance uncertainties, offering benefits to both buyers and sellers. However, their complexity means that clear structuring, transparent terms, and effective dispute resolution mechanisms are essential.