THE VALUE OF USING EARNOUTS TO FINANCE A TRANSACTION
Earnouts are becoming increasingly popular as a means of financing transactions, and also reducing the business risk for the purchaser. They are typically used to bridge valuation gaps between both parties. An earnout allows the purchaser to pay less up front today, in return for a promise of a share in the future profits or cash flow of the business.
There are a number of reasons why you should consider earnouts:
From the sellers perspective
It offers an opportunity to share in the future profits of the business. So for example, if the business is being sold to a much larger entity, the seller may be able to share in a % age of a much larger profit than if it were a standalone basis. This gives them an upside to the transaction, which otherwise might not have been achieved by simply using the traditional EBITDA valuation methodology.
It may also afford the seller the option of remaining on in the business for a period of time, to manage the transition to the new owners, or to work part time for an agreed tenure, with a specific brief (such as business development, new product development, R&D, tendering etc). It also could allow the seller to remain on working, but not to have to worry about the day to day administration of the business, and focus on the areas they enjoy, adding significant value.
From the buyers perspective
It offers the buyer the opportunity to pay less upfront and therefore commit less cash flow or borrowings, so that there is enough cash to invest in strategic development. This reduces the risk while the business is in transition. It may also make it easier to raise third party (ie bank or equity) finance.
The earnouts are usually paid from profits generated by the business, so there is no need to raise additional finance to pay for these. If they are based on profits, then if things don’t work out, they do not become due.
However, there are a few issues which need to be addressed when considering the earnout option:
• Basis of the calculation- eg is it based on profits and if so how exactly are these calculated? Ideally, they will be on a consistent basis as prior years, but that is not always the case. This needs to be agreed as part of the deal, and should be kept as simple as possible.
• In some cases, the earnout can be based on % of business retained, or new business generated. This will require a sharing of information between both parties.
• Security of payments – the seller needs to know that by deferring some of the consideration until a later date, they will still receive the full amount, as it falls due. There are ways of protecting this when agreeing the legal contract, such as taking security over certain assets, or company shares.
• Length of time of the earnouts payments. Typically, the shorter the better. The buyer will want to
Skillful negotiation will be required to get the optimal deal structure. Your professional advisers can assist with this, and in ensuring that each parties’ interests are protected as much as possible.