Businesses operating within the U.S. market have been facing a growing list of challenges. Rapidly rising interest rates, reduced access to equity investment and debt facilities, and continuing supply chain issues, as well as the lingering effects of the COVID-19 pandemic, have forced many businesses to rethink their operations and reevaluate their financial models. This market volatility presents a unique set of challenges for companies that either wish to sell all or part of their business or otherwise wish to expand their operations through the acquisition of another company.
Any business considering a merger, divestiture or acquisition (M&A) – from either the buy or sell side – may consider utilizing an earnout provision. Earnout provisions provide for a portion of the purchase price to be paid in future installments based on the performance of the acquired business after the closing of the transaction. Typically, payments are conditional on the acquired business achieving certain agreed-upon metrics, such as sales, revenue or gross profit levels. Often earnouts operate on a sliding scale within a minimum and maximum range, where the payment amount within this range increases based on a formula as the agreed-upon metrics are met or exceeded. This mechanism helps align the interests and valuation expectations of buyers and sellers and reduces the risk of overpricing or undervaluing the acquired company.
But how does the current market volatility impact the way an earnout provision should be structured? This article will provide an overview of the increased use and scrutiny of earnout provisions in M&A deals during a down or volatile market. It considers how economic macro conditions impact the way earnout provisions should be drafted in M&A deals from both the buyer and seller perspectives.
Advantages and Challenges of Using Earnouts
One of the primary challenges of using earnouts in M&A deals is the uncertainty of future performance. The COVID-19 pandemic and current economic policy to address the inflationary pressure that has arisen as the world has emerged from this crisis have created unique challenges for businesses, and these have led to an uncertain economic climate, which makes predicting future financial outcomes of a target company particularly challenging. In this situation, determining the appropriate earnout formula or milestones can be difficult.
Earnouts can provide a benefit to a buyer by delaying payment of a portion of the purchase price and ultimately reducing risk by tethering the purchase price to the performance of the newly acquired business. Utilizing an earnout may also be advantageous to a buyer during a bidding process – allowing a potential buyer to present a larger possible purchase price, while still minimizing risk around a target’s earning potential.
The use of earnouts comes with its own challenges, however. Earnouts represent uncertainty in the final purchase price and risk to the seller. How a particular business will fare after a sale will depend on factors both inside and outside the control of management. An economic downturn may negatively impact at least the short-term ability to maximize the earning potential of a newly purchased business. Similarly, the buyer and the seller may have conflicting views regarding how the acquired business should be operated. An earnout is likely to cause the seller to be more focused on short-term growth, while the buyer may be more invested in the long-term success of the company. In the event an earnout threshold is met, buyers may have to secure additional sources of financing to pay the earnout amount, which may be more costly than anticipated.
Even under good market conditions, earnouts require careful drafting, but a down or volatile market exacerbates these concerns. Sellers will always want the agreement to include protections regarding the ability to freely operate the business without interference from the buyer or changes with which they may disagree, such as changes in the management team or key employees, the incurrence of additional costs they deem unnecessary, or imposition of additional overhead on the business. Sellers may also be concerned about matters that are specific to the buyer, such as changes in the buyer’s business that could impact their earnout, including additional acquisitions; restrictions on a buyer’s business that limit customer growth, such as industry verticals in which they cannot pursue new business because of noncompetes; requirements to focus on less-profitable business lines due to synergy issues with the buyer; a change in control of the buyer or a material adverse change in the buyer’s business unrelated to the target business. Buyers, on the other hand, want the ability to integrate the newly acquired business into their overall business and to have the seller’s operations conform to other parts of their business as well as potentially to either impose potential short-term cost-cutting measures on the business or require additional investments that could hamper or distract from achieving the earnout milestones. Therefore, buyers resist controls that might tie their hands or require specific actions on their part. They generally will not want any obligation to cooperate to maximize earnout potential or have any fiduciary-type obligations to the seller. As a general rule, a buyer will want minimal controls on its ability to operate the business and, at most, an obligation to act in good faith so as not to interfere with such operations in a manner intended to materially and adversely impact a seller’s ability to achieve an earnout. These covenants become very complicated and require significant thought and analysis.
Earnout Trends From the 2022 Financial Year
The 2023 SRS Acquiom M&A Deal Terms Study¹ provides a useful overview of how earnouts are being used under current market conditions based on data trends observed throughout the preceding year. In 2022, approximately 21% of non-life science deals2 included an earnout provision. This represents a somewhat significant increase from the 2021 period, which had 17% of M&A deals use an earnout. Overall, this figure has been increasing since 2018 (a year in which we saw the year close with the worst stock market declines and volatility since the financial crisis of 2008), which saw a low of 13% of deals using earnouts but is comparable to the 2017 figure of 23%.
Of the 21% of 2022 deals that included earnouts, 42% of these had a single trigger event, while 58% had multiple trigger events. Of these trigger events, revenue-based triggers were the most significant, representing 61% of the total deals. Trigger events relating to hitting certain earnings or EBITDA targets represented 23%, while 22% of deals used other forms of measurement (including such things as unit sales, product launches or divestiture of stocks).
In terms of earnout numbers as a percentage of the overall deal size, the median earnout potential as a percentage of the closing payment3 remained relatively steady, at 31%, compared with the 30% figure from the 2021 period. Meanwhile, earnout length had a median period of 24 months, with 30% of earnouts being one year or less and 85% of earnouts having a period of three years or under.
The use of certain earnout covenants was also considered by the SRS Acquiom study. Covenants to run the business in accordance with the seller’s past practices were included in only 23% of all earnout provisions surveyed. A mere 1% of earnout provisions included language requiring the business to maximize earnout payments. Earnout acceleration upon change of control was implemented in 30% of all deals included in the study. Finally, 73% of earnout provisions allowed the buyer to offset indemnity claims against future earnout payments.
Specific language disclaiming that earnouts are not considered securities was increasingly used in the 2022 period; approximately 45% of all deals included such language, up significantly from 30% in the 2021 period. Finally, 19% of earnouts specifically disclaimed a fiduciary relationship between the parties.
Use of Earnouts for Bridging Valuation Differences
Earnouts can be particularly useful when there is a valuation gap between a buyer and seller, a situation that becomes more prevalent when a market quickly changes direction, as we have seen over the past 12 months. By agreeing to an earnout, both parties can align their interests and work together to achieve specific financial metrics. In this scenario, an earnout can act as a bridge between the two parties, providing the seller with the potential to receive additional payment and the buyer with the ability to spread the acquisition cost over time and not overpay if the targets are not achieved. Additionally, where a target company has a short operating history, earnouts may be a useful tool for sellers to increase their valuation price.
Down-Market Controls To Negotiate in Earnout Provisions
- Be specific with performance metrics. Uncertainty in the market has caused both buyers and sellers to seek more control over their exposure to performance metrics. For sellers, this often materializes as heightened concern over whether the metric is practicably achievable under current market conditions and a push for more conservative milestones, as failure to reach the metric results in a lower purchase price, often leading to seller’s remorse as the seller receives less than it thought the business was worth. Meanwhile, buyers will typically seek to limit the risk of overpaying for the target company if the performance metrics are not achieved or only partially achieved. The buyer will still be pushing for reasonable growth targets that may be unpalatable to the seller. In negotiating targets that are reasonably acceptable to both sides, parties should draft the earnout provisions with specificity, including resolving issues of ambiguity with respect to accounting principles, overhead costs, intercompany charges and other factors that could impact the measurements in a way that varies from historical seller practices. While these issues are common to earnouts in any situation, whether or not it is a down market, defining the metrics is harder in a volatile market, where there are at play macroeconomic factors, such as inflation, increasing interest rates and supply chain issues that increase costs and make it harder to project results for the near term.
- Consider the length of the earnout period. The macro conditions of the economy can have a significant impact on performance metrics. During a down market, it may be more challenging for a newly acquired company to meet financial metrics that would have been more achievable in a steady market. To address these concerns, parties should consider provisions that mitigate the impact of macroeconomic conditions. This includes the use of measurement periods that could be longer than those in typical earnout provisions, which would allow a target company more time to achieve specific financial metrics.
- Consider “catch-up” or proration clauses. Ambiguity in a down market primarily concerns uncertainty about predicting future performance. Rather than draft an earnout provision to be “all or nothing,” parties should consider a sliding scale of payments. Alternatively, “catch-up” earnout provisions give sellers the right to collect at least a partial earnout payment if an acquired company fails to meet a specified target in one year but makes up the deficit in a subsequent year.
The use and scrutiny of earnout provisions during a down market have become increasingly common due to the uncertain economic climate. Despite the challenges associated with using earnouts and the need for careful drafting of these provisions, earnouts are still a useful tool for bridging valuation gaps and aligning interests between the buyer and seller.
1 SRS Acquiom Inc., M&A Deal Terms Study (2023), available at: https://info.srsacquiom.com/2023-srs-acquiom-deal-terms-study.
2 Earnouts are considered the industry standard in life-science deals and, as such, tend to skew overall figures, so such deals were excluded from the study.
3 Calculated as the sum of potential earnout payments over the amount paid at closing, including escrowed amounts.
About the Authors
Evan Poulgrain concentrates his practice on corporate law, advising public and private and private companies in various corporate transactions, including mergers and acquisitions, divestitures, entity formation and corporate governance issues
Lori Smith is chair of the emerging companies & venture capital practice and is an active participant in the firm’s health law and mergers and acquisitions groups.
Josh Galante is a member of the firm’s business department and focuses his practice on complex business combinations and investment transactions.