Incentive or Illusion: Unpacking Earnout Mechanisms
-
2024年2月23日
-
We recently emerged from a period of record-breaking valuations. Now, as large price expectation gaps recede, sellers are adjusting to a new reality. Earnout mechanisms are popular tools used to bridge valuation gaps between deal parties and get the deal done. However, they are prone to dispute. This article highlights some of the most common pitfalls in drafting, calculating or agreeing earnouts.
After a subdued year in 2023, M&A activity is forecast to rebound in 2024. With interest rates expected to stabilise, sellers are coming to terms with lower valuations. Meanwhile, private equity firms are motivated to exit long-held positions.
But even as the gap between buyer offers and seller expectations may be narrowing, a full valuation correction does not appear to have yet materialised. This lingering discrepancy continues to mean that the expectations of the parties can be far apart, which can cause friction over deal value and potentially scuttle transactions.
Earnouts (or deferred or contingent consideration) can be an attractive “downstream” tool where there is disagreement over the deal price. They allow parties to get the deal done by deferring part of the purchase price and linking that to certain performance measures to be determined at agreed points in time, following the completion of the deal. They’re attractive in a market where the cost of capital is high, as they require less cash up front, and they provide the buyer with some downside protection, should the acquired business fail to perform.
However, because earnouts are often born out of an inability to agree on the target entity’s value in the first place, they can expose both parties to risks post-completion. Accordingly, it is vital that the earnout clauses in the share purchase agreement (“SPA”) are drafted with caution in order to minimise the chances of a dispute.
From my experience, there are several areas that commonly give rise to arguments over the earnout amount. Each calls for close attention when drafting the agreement.
How Does Change of Ownership Affect the Calculation of Earnout?
Upon completion of a deal, it is very common for the purchaser to align the target’s accounting policies and practices with its own group accounting basis. The acquired target may be subject to fundamental reorganisation or integration into the acquiring entity; this may include introducing or merging central functions in areas such as IT, or new intercompany financing or group charges (for management or other central functions) which were not present under the seller’s ownership. All these factors can distort the target’s profitability post-acquisition.
Typically, it is important that the accounting policies and principles under the seller’s ownership continue to be applied in the earnout calculation, to avoid such distortion which is typically under the control of the buyer. But it’s of fundamental importance that the SPA unambiguously defines whatever policies are to be used in the earnout calculation.
The SPA should clearly set out the way in which the parties are to deal with post-acquisition adjustments arising from the purchaser’s restructuring or rationalisation of the target in the preparation of earnout statements. Attaching a template or worked example of the earnout calculation basis to the SPA can help minimize the risk of unintended inclusions or omissions of items in the earnout.
What’s the Right Measure?
Turnover (sales or revenue) and EBITDA are the two common financial measures used as the basis of earnout formulae. Each has pros and cons.
Turnover is normally harder to manipulate as well as easier to define. But it does not reflect the profitability of the target. For example, turnover is a commonly used earnout reference measure in deals involving pre-profit targets such as those in the technology sector. By contrast, EBITDA is a measure of profitability, yet is not defined in accounting standards such as UK GAAP and IFRS, and it is consequently open to subjective interpretation (and manipulation). Whatever the measure, care should be taken to define the earnout formulae in the agreement. Furthermore, it is highly recommended that those formulae are as simple as possible and are tested to ensure they reflect the parties’ intentions.
Is There a Ratchet with Large Steps in the Earnout Mechanism?
Earnout calculations can include a ratchet by which the sellers can achieve a significantly higher earnout should a higher target be met. In some deals, the earnout steps can go up by a large multiple (e.g., if sales exceed X, then the earnout increases from £10 million to £20 million). Where this is the case, and where the measure is close to the threshold, there will almost inevitably be a dispute about very small numbers around the steps in the ratchet, as both parties attempt to move profit above or below the ratchet trigger to obtain a price advantage.
Smart Structures = Smooth Sailing
It is generally desirable to keep the structure of earnout clauses simple and to aim for a fairly short earnout period. It’s also prudent to choose metrics that are closely related to the value of the target entity and that cannot easily be manipulated.
Another general observation is that the performance measure underlying the earnout calculation should be higher up the income statement, such as sales or volumes sold. These figures are generally less prone to subjective interpretation or manipulation, and thus less likely to lead to disputes, than profit. Example calculations should appear in the sale and purchase agreement exhibits.
Further, as little as possible should be left to the buyer's discretion when preparing the earnout figures. Finally, it is important to apply consistent accounting policies and ensure access rights for both parties.
These ideas are further explored by my colleague Heiko Ziehms in his latest book entitled M&A Disputes: How They Happen, How to Resolve Them, How to Avoid Them.
In short, earnouts are a means of aligning parties who might otherwise be at odds, and can help keep sellers involved in a business. They can be a win-win to facilitate a deal. But they should be used carefully and with a clear understanding of the risks involved. By addressing the issues outlined above, parties can greatly reduce the chance of a dispute.
出版
2024年2月23日
主な連絡先
マネージング・ディレクター