The key issues of earn-outs, and how to avoid them

Earn-outs are a popular tool in for structuring M&A deals, and are getting more popular by the year. But they’re not without challenges. So how can we avoid the most common pitfalls of earn-outs?
A dispute after an earn-out

Earn-out, a part of the total purchase price that is subject to the future performance of the target company, is still commonly used in transaction structuring. From a helicopter view, it seems a good tool to bridge the gap in the seller vs. buyer views in the business outlook, and consequently in valuations.

The appetite for earn-out structures might even increase in these turbulent times. Especially when bid-ask spreads grow between seller and buyer, for example when the buyer intends to achieve valuation discounts that reflect declining valuations on capitals markets imminently, as opposed to the buyer sticking to previous valuation levels claiming that fundamentals of the target did not deteriorate (at least, not to the extent which can be experienced in capitals markets).

In this article, we will analyze if earn-out is always the right solution and if we can fix the common pitfalls.

The challenges with earn-out

In most cases, earn-out parameters are pretty much simplified (revenues, EBITDA, net profit, etc.): convenient, and easy to measure.

However, there are also quite a few disadvantages in applying an earn-out like that:

  1. Integration:  If such high-level targets are set, no (legal) integration is possible during the earn-out period. That makes it difficult for the buyer to fully exploit synergies.
  2. Contribution: Future disputes whose contribution was the achievement of the targets – buyer or seller?
  3. Manipulation:  Awkward discussions / suspicion of financial manipulation (increase/decrease in costs, bring forward/postpone revenues).

In the worst case, tensions around earn-out numbers might result in losing value in the target company – which all buyers of course want to avoid.

Nevertheless, the challenges what the earn-out intends to solve are there.

But if not high-level earn-out targets – then what can we do?

A poorly structured earn-out can lead to serious disputes between buyer and seller. Better to avoid them.

How to approach a successful earn-out structure 

Rather than using the plain vanilla earn-out structure and general high-level financial targets, put some more work up-front to identify and work out very specific targets for the former owners. Setting revenues, EBITDA, and net profit targets might be easy and convenient, but can be the source of many future disputes (see above).

Be very specific and make sure to draw a line for clear responsibilities. Identify specific value drivers on which the seller has a direct influence in the future and measure the seller’s performance as set in these specific KPI set.

With this approach, the integration process can kick off immediately, every stakeholder has its clear objectives and potential conflicts may also be managed or, best case avoided.

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