M&A Deal Structures: Is an Earnout the Best Solution?

Blog by Ben Greenberg, VP of Corporate Development at IT Solutions

If you’re considering M&A initiatives or navigating the challenges of growing your business, we invite you to connect with Ben (Benjamin.Greenberg@itsolutions-inc.com).

Please note: this article does not intend to provide legal or investment advice.

Successfully finalizing an M&A deal isn’t always straightforward, especially when there’s a perceived value gap or a significant difference in risk allocation between what buyers are willing to absorb and what sellers are willing to accept. The solution is often an earnout to bridge the gap.

This article delves into the intricate dynamics of earnouts in M&A deals, including:

What are earnouts, and how do they work?
The pros and cons for buyers and sellers.
Best practices to help you craft effective and fair deals.

What Is an Earnout?

An earnout is a contractual agreement between buyers and sellers where a portion of the purchase price is contingent on meeting specific financial and/or operational goals. Initially, the buyer pays a portion of the agreed-upon selling price at closing, but the remaining amount is only paid if key performance metrics are met.

Let’s take a simple example. A seller may want $20 million for their company, but their success is recent and lacks a well-established track record. Buyers may value the company at $15 million based on longer-range assessments. This gap could derail the deal. An earnout is designed to bridge that gap. In this case, a buyer may agree to pay the additional $5 million only if the acquired company continues to perform at the current level for a period of time to substantiate the seller’s thesis.

How Common Are Earnouts in M&A Deals?

Since the pandemic, a significantly higher number of M&A deals include earnouts. This is not surprising when you consider the economic uncertainty and significant disruptions to various industries. Buyers’ concerns about whether past performance is truly an indicator of future profitability are driving a higher adoption rate of earnouts.

A review by the Harvard Law School Forum on Corporate Governance found that about 37% of M&A deals in 2023 contained earnouts (excluding development-stage deals and de-SPAC transactions). That compares to about 20% in 2018 and 2019.

How Are Earnouts Calculated

Earnouts are determined in various ways, but the most common method (especially for standalone businesses) is based on adjusted Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA), with the earnout being tied to a multiple.

Here’s a straightforward example:

Consider that a seller’s earnout is contingent on at least $1 million growth in EBITDA over the next year.
If the seller’s EBITDA achieves $1 million more than the original EBITDA when acquired, the seller receives 3X for every dollar above that mark.
- If the business achieved EBITDA of $1.2 million during the period ($0.2 million above the target of $1.0M), the earnout would be $200,000 x 3, or $600,000, paid to the seller.
- However, if the EBITDA does not increase by $1 million, there is no additional payout as the target EBITDA goal was not met.

Earnouts aren’t always that simple, though. They can be tied to revenue, clients, operational goals, synergies, and other metrics. Like most things, the details matter greatly. Is an earnout deal structure right for you? Let’s take a closer look.

Pros and Cons of Earnouts

The overarching goals for earnouts are to close the valuation gaps for both parties and break deadlocks in purchase-price negotiations or to distribute risk more proportionally. In some cases, earnouts can also be a way for sellers to provide financing to help buyers meet the ultimate selling price when buyers don’t have access to the necessary funds.

When deciding whether an earnout is right for your deal, you need to consider both the advantages and disadvantages.

Pros

Earnouts are a popular way to structure an M&A deal for several reasons.

Higher Confidence for Buyers
Earnout structures ease a buyer’s uncertainty regarding their investment since the total purchase price depends on the future performance of the acquired company. If the business underperforms compared to projections, the buyer pays less overall. This directly ties the price paid to the financial outcomes achieved post-acquisition.
More Flexible Payment Timeline
Rather than a large lump-sum payment, earnouts allow buyers to pay the purchase price over an extended period as performance milestones are hit. This can ease financial burdens, especially for smaller buyers or those with tight liquidity. The contingent nature matches costs to operational results.
Lower Initial Payment
With an earnout, buyers structure a lower upfront payment upon closure of the acquisition, with future payments contingent on metrics. This makes the initial investment more affordable while still providing potential compensation to sellers later for overperformance.
Ongoing Income Potential for Sellers
As opposed to sellers receiving a single lump-sum payout, earnout terms have the purchase price paid over time as milestones are achieved post-close. This provides sellers with a stream of potential payments over multiple years rather than just at the point of acquisition.
Tax Advantage Possibilities
The incremental nature of earnout payments over several years means the tax obligations for sellers can be spread out as well. With tax planning, it may be possible to minimize tax burdens compared to immediate taxation on a full lump-sum change-of-control payout.
Incentives for Sellers to Ensure Success and Potentially Overperform
Since buyers only pay the full purchase price if the business remains successful in the years after the acquisition, sellers are incentivized to maintain and improve operations, reputation, and growth trajectory. Buyers will often include opportunities to increase value if the acquired business outperforms expectations.

Cons

There are also some downsides that buyers and sellers need to take into consideration.

Complex Tracking and Measurement
Earnouts can be complex to track and hard to measure, even when tied to well-defined metrics like EBITDA. Let’s say the buyer agrees to pay a multiple of EBITDA. However, after the acquisition, the buyer makes operational changes to the organization, and the target EBITDA is not achieved. Sellers may claim that these changes are the reason the target was not achieved.
Legal Disputes
Bloomberg Law examined the number of legal disputes in light of the rising use of earnouts in M&A transactions and found a similar uptick in federal and state court filings. In fact, legal filings mentioning earnout disputes doubled from Q1 2022 to Q1 2023.
Misaligned Incentives
There can be misaligned incentives as well. A seller hopes to maximize their ultimate sale price based on future projections. However, MSPs acquiring new businesses are typically looking to integrate operations. Buyers aren’t going to just continue as is but will look for ways to streamline processes, work more efficiently, and achieve economies of scale. A buyer may agree to EBITDA as a benchmark but focus efforts more on cash flow for reinvestment or organic growth.
Continued Seller Commitment
Depending on the terms of the earnout, sellers have a continuing interest in the business. This may require continuing consultation on business practices. In other cases, sellers may have no ongoing role but, due to the potential payout, will continue to monitor the business and offer advice that may or may not be welcomed.
Accounting and Taxes Become More Complex
Earnouts add complexity to accounting and taxes due to contingent purchase price allocation, ongoing valuation of future liabilities, unpredictable tax planning implications, ambiguity in tax deductibility of payments, and more granular record-keeping requirements.

Future earnout payments become liabilities that the buyer takes on. Because they are unpredictable, especially early in deals, the tax planning can vary greatly.

Best Practices for Earnouts

Employing best practices can help both buyers and sellers avoid disputes and create a fair and equitable deal. Here are some of the best practices that can help craft a successful earnout agreement.

Best Practices for Buyers

1. Focus on Simple, Clear Metrics
When determining the metrics that the earnout payments will be based on, buyers should keep it simple. Complex formulas with multiple variables and moving parts increase risk. Instead, identify one or two straightforward financial benchmarks like revenue growth, gross profit, or EBITDA to use over the earnout period, whichever aligns closest to the company’s core financial or operational objectives. Define exact calculations clearly in the purchase agreement.

Ambiguity leads to future disputes. Sticking with linear payout scales based on performance against predefined thresholds or growth rates simplifies projection modeling during valuation as well.

2. Maintain Control to Operate the Business
During an earnout period, buyers need reasonable control to make operational decisions they deem necessary to run the business successfully. Buyers should model any dramatic changes to address the impact on metrics post-acquisition. Operating in good faith based on these models helps craft fair deals.

Still, buyers must retain flexibility to adapt to market conditions. Ensure purchase agreements clearly specify rights to make staffing adjustments, amend budgets and marketing spend, invest capital into growth priorities, adjust product mix and pricing, and take any actions that leadership determines prudent.

3. Institute Ceilings to Contain Maximum Payouts
While sellers naturally prefer uncapped earnout upside potential, buyers should institute payment ceilings to limit maximum exposure, with the ceiling aligned to the projected valuation range. This cap mitigates the risk of significantly overpaying if performance well above baseline projections is achieved.

Ceilings still allow substantial incentive structures for sellers to drive growth. Pairing this with reasonable floor values and guaranteeing a minimum payment to sellers absent disastrous performance can balance both parties’ interests. Sensible guardrails preserve ROI models.

4. Structure Time Horizons to Reduce Risk
Lengthening the earnout period reduces risks for buyers by distributing contingent payments over time. The typical earnout period ranges from one to three years, although there are many cases where the earnout period goes substantially longer. Five-year earnouts are not uncommon in some industries.

With extended timeframes for achieving performance milestones, there is a greater likelihood that external market variables and statistical anomalies will balance out. This proves more advantageous compared to the potential for skewed results over a shortened window. Additionally, greater time also allows making operational changes to fully integrate the acquisition while extended payment structures ease immediate liquidity burdens.

Best Practices for Sellers

1. Push for Metrics that are Most Controllable
In most cases, sellers should advocate for structuring earnout payments based on revenue growth vs. profitability metrics.

However, metrics that align to growth (or have a direct impact on revenue) still often reflect broader decisions partially outside sellers’ control after acquisition. Growth Metrics are typically much more controllable within the scope of a seller than direct profitability metrics (like EBITDA), maximizing a seller’s ability to hit targets while providing ongoing business momentum for buyers.

2. Understand Operational Control Rights
During earnout periods, sellers should look for adequate rights in purchase agreements to make certain operating decisions that impact the performance metrics underlying contingent payments. For example, this could include maintaining budgetary control over sales and marketing investments required to drive top-line expansion.

Shared oversight can provide checks and balances.

3. Negotiate Accelerated Payout Provisions
Sellers should negotiate clauses triggering earnout payments if buyers themselves get acquired during the earnout term. Accelerated payouts generally are proportionate to goal achievement during the period. Without this clause, buyers may steer strategic decisions toward their acquirer’s interests rather than sellers’ earnout incentives.

Accelerated vesting gives sellers recourse and ensures they don’t leave money on the table if the business changes hands earlier than anticipated. Enabling this protection aligns with fair value exchange for giving up control and discourages buyers from selling just to limit earnout payouts.

4. Structure for Preferential Tax Treatment
Sellers should always consult with legal and tax advisors as part of structuring any M&A deal. Properly classifying contingent payments allows more preferential tax treatment for sellers by qualifying amounts as capital gains rather than ordinary income. Categorizing portions of earnout payments as deferred acquisition value or consulting arrangements impacts IRS rules on installment sale eligibility.

5. Incentivize Employees to Remain Post-Acquisition
Implementing separate retention bonuses, stock, or shared earnout pools for key staffers motivates employees to remain under new ownership. This helps ensure that key contributors continue to feel encouraged and drive positive outcomes.

In some cases, buyers may help fund these incentive plans since retention of critical staff helps with hitting milestones. With shareholders cashing in on liquidity events from sales, providing mechanisms for employees to financially benefit ensures they remain invested in company growth required to trigger contingent payments.

Staying Focused on Priorities

As you can see, there are times when these best practices for buyers and sellers can also be at odds. You may not be able to achieve every deal point or get everything you want. Deal making is a negotiation, and you need to focus on your priorities first.

Dispute Resolution

For both parties, it’s also important to address how earnout disputes are resolved. By the time disputes end up in legal action, both parties rack up legal bills and have to take time away from business operations. Many earnouts include alternative dispute resolution (ADR) mechanisms, such as using an independent audit or arbitration to resolve disputes and avoid court costs. While this does not preclude legal action, it provides an alternative to costly litigation.

M&A Deals Can Be Complex

M&A deals often include more than just selling price and earnout provisions, adding to the complexity of navigating and constructing the right deal. Deals for MSPs, for example, may include multiple components besides earnouts, including:

Cash at Closing: Upfront payment wired from buyer to seller at closing; makes up a large portion of deal value. A portion of cash is typically held in escrow for a period to protect against indemnity claims.
Rolled Equity: Sellers take a portion of the proceeds as equity in the purchasing company. This can typically be lucrative if you believe the purchasing company will create significant future enterprise value.
Seller Notes: Essentially a loan from the seller to the buyer to finance a deal. Locks in returns for the seller via interest payments while enhancing the buyer’s return on equity.
Retained Equity: Sellers keep an ownership stake in the acquired company and help align incentives.
Revenue Share/Business Development Partnerships: An alternative to acquisition for bolt-on deals. Payments tied to revenue generation over time mitigate the buyer’s downside risk.

Finding the Right Balance for Successful Deals

Crafting successful M&A deals requires balancing multiple elements beyond just valuation. Earnouts can help bridge gaps between buyer and seller expectations but also introduce complexity. By focusing negotiations on clear metrics aligned with priorities and instituting dispute resolution guardrails, both parties can mitigate risks.

Ultimately, buyers and sellers need to carefully weigh all the pros, cons, and options relative to their goals and priorities. Finding common ground and negotiation in the spirit of good faith partnerships can create deals fostering upsides for both organizations.

Taking the Next Step?

Embarking on a journey of M&A growth is both thrilling and demanding. If you’re considering M&A initiatives or navigating through the challenges of growing your business, we invite you to connect with Ben Greenberg, VP of Corporate Development at IT Solutions (Benjamin.Greenberg@itsolutions-inc.com).