Earnouts: Structures For Breaking Negotiation Deadlocks

M&A ToolKit: Effective Structures For Breaking Purchase-Price Deadlocks and Mitigating Downside Risk.

The Ugly Business of Negotiation Deadlocks

The process of buying and selling firms is, by nature, complex and lengthy. Whether the reason be as part of a growth-through-acquisition strategy or a founder seeking to raise capital via a part-divestiture, M&A can be distilled into two components: valuation and risk allocation. In my many years as an M&A practitioner and expert, I have witnessed many an occasion where strategically accretive transactions to both parties fail to be consummated for differences in ascribed valuation or for an inability of the buyer to mitigate risk. In other instances, clever structuring has bridged differences between two divergent parties to great result, such as in Extreme Network’s acquisition of Broadcom’s Data Center Business, which leveraged various forms of deferred and contingent payments.

As abstract concepts, both valuation and risk are rooted in the future free cash flows of the target enterprise. Specifically, valuation, often represented as the enterprise value, is the present value of a company’s future cash flows discounted to present day at its weighted average cost of capital. The implied risk is embedded within the relative uncertainty of these future cash flows.

Unfortunately but oftentimes, exogenous factors in a dynamic marketplace increase the relative uncertainty around future cash flows so as to push both buyer and seller views on valuation outside the zones of agreement. When this occurs, contingent forms of payment, which include earnouts, escrows, holdbacks, and clawbacks, often represent the only available tools to break the negotiations deadlock.

This article explores the structuring and use of earnouts, specifically, as one such tool for bridging valuation deadlocks in M&A deal-making. As part of this process, I will seek to arm both buyers and sellers with (1) an understanding of the benefits and risks to earnouts; (2) insight into when earnouts are best used and are most effective; (3) an analytical framework for understanding earnouts’ constituent/structural elements; and (4) empirical evidence that earnout structures do also serve as effective downside/risk mitigation tools.

The Basics: The What and the Why

Our first question must be, what is an earnout? An earnout is a contractual arrangement between a buyer and seller in which a portion or all of the purchase price is paid out contingent upon the target firm achieving predefined financial and/or operating milestones post transaction-close. Earnouts confer a range of benefits to those who utilize them.

Benefits to both parties:

• Break purchase-price deadlocks between buyers and sellers;
• Force difficult conversations between the selling or surviving management team and the buyer around how the asset will be operated post-acquisition.

Benefits to buyers:

• Reduce the quantum of capital that must be put at risk at the point of transaction-close;
• Afford the buyer the opportunity to anchor the fair market value of the target on its performance and not sentiment;
• Shift the risk of post-merger/acquisition underperformance from the buyer to the seller;
• Create a source of alignment and retention for the target firm’s surviving management team by affording them attractive, milestone-based time and performance incentive packages tethered to post-acquisition outcomes;
• Provide an effective deferred financing mechanism that may afford undercapitalized buyers the opportunity to still acquire an attractive target with time to bridge the remaining capital requirement. In most cases, the buyer is actually able to partially pay for the acquisition from earnings from the target firm;
• Exist as a self-selection mechanism — low-quality target firms are generally reluctant to accept this type of structure given that the target firm’s management knows the earnout has a low probability of success; and
• Let the target asset prove its worth.

Benefits to sellers:

• Afford the opportunity for an ambitious sale price, should said seller be willing to earn it — a purchase price that would ordinarily be unattainable at the then current discounted cash flow valuation assessed by the buyer.

As with most structured finance solutions, there also exist some clear disadvantages to earnouts. The greatest of these is the potential for litigation in the period between transaction-close and the earnout’s expiration. Although in theory, earnouts align the interests of both buyer and seller to post-acquisition financial and operating success, there are several areas where interests, plans, and preferences still diverge.

The most common of these is how the target firm will be run en route to achieving the mutually agreed-upon targets. This challenge is most common where the acquired firm becomes part of a larger business and strategy and is thus expected to operate differently from how it did as a standalone entity. Though the scope of this article doesn’t extend as far as exploring litigation issues, contractual provisions should be put in place that protect buyers against potential litigation from sellers.

These contractual provisions typically fall into two categories. The first is to negate any and all implied obligation on the part of the buyer to achieve the earnout such that unsatisfied sellers cannot invoke covenants of good faith and fair dealing that claim the buyer operated the target firm in a manner that frustrated the company’s achievement. And the second provision should stipulate that the buyer has absolute discretion over the operation of the target firm post-acquisition.

The Zone of Possible Agreement

As previously mentioned, during a negotiation, buyers and sellers will usually have differing views on valuation. This is no cause for concern so long as their views fall within the zone of possible agreement (ZOPA). However, and as previously alluded to, circumstances do arise whereby the degree of uncertainty surrounding the target firm’s future cash flows is so high as to push both parties’ views outside of the ZOPA. These circumstances typically fall into one or more of the following categories:

1. Lack of operating and financial track record
2. Recently restructured organizations — specifically, organizations that have recently undergone such dramatic internal changes that their financial and operating track-records, and thus projections, are no longer credible predictors of the future
3. Major shifts in strategic direction coming in the form of new business units, major new product lines, or major new geographical bets, which again make past performances inaccurate guides of the future
4. Concentration and key-man risk that range from customer concentration, supplier concentration, and capital source concentration to key man risk, especially where founders are still active at the point of sale
5. Heuristics and personal biases, which are typically driven by either past personal or professional experiences or cultural affectations (where cross-border transactions are concerned) that can drive sometimes insurmountable divergences in expectations

Beyond these, other variables do exist that also push up or down ascribed value during M&A negotiations. One such example is sentimental attachment by sellers that drive up price, which most often occurs when founders choose to sell their companies (i.e., their “life’s work” or “baby”). Buyers also have their set of emotional drivers. One such common example is buyers who undervalue a target as a fear induced knee-jerk reaction to a past experience gone bad.

Structuring Earnouts — A Simulated Case Study

Based on my many past experiences, I have constructed a case study that will help simulate and explain how to structure an effective earnout. It is as follows:

Firm A (buyer) has conducted an internal strategic review and concluded that it suffers an important product gap. Its competitive landscape has evolved such that its customers now prefer one-stop-shop solutions that include Product X, which it does not currently produce. Given that speed to market is critical in Firm A’s arena and it has great knowledge of its competitive landscape, it opts to acquire a startup, Firm B, which specializes in Product X. NDAs and financial and operating data begin to be exchanged in a data room.

Firm B conducts its internal discounted cash flow analysis (DCF) that yields an Enterprise Value (“EV”) of $16 million, below:

Firm A conducts its DCF analysis that yields a materially lower EV of $4 million, below:

The Negotiation

Firm A puts forward an offer of $4 million and Firm B counters with an ask of $16 million, pursuant to which both firms meet and negotiate face to face. Firm A explains that Firm B has only one year (2017) of financial history and that, though profitable, they are yet to prove that they can capture market share from other competitors.

Conversely, Firm B explains that Product X is powered by patented, proprietary technology (lower cost) and is sufficiently differentiated from other products in the market to not only capture share but create new demand. Firm B’s view is that this will drive revenue growth at rates well in excess of industry averages.

After days of negotiations, both firms find themselves in a purchase price deadlock depart without an agreement.

Figure 3, above, illustrates/reflects the buyer’s model and assumptions — the x-axis shows Firms B’s EBITDA 3-year CAGR and the y-axis shows the implied enterprise values. The buyer’s EV function reflects the range of implied EV possibilities for Firm B as a function of the discount rate, revenue growth, and cost basis assumptions it assumed during its analysis.

Given that Firm A understands the strategic value to acquiring the capability to manufacture Product X as soon as possible, it opts to design an earnout structure that bridge the valuation gap, driven by its future cash flow concerns and thus breaking the negotiation deadlock.

The Process of Structuring

The following section looks at each of the key elements to consider when structuring an effective earnout, of which there are seven: (1) total/headline purchase price, (2) up-front payment, (3) contingent payment, (4) earnout period, (5) performance metrics, (6) measurement and payment methodology, and (7) target/threshold and contingent payment formula. These elements are best explained and understood sequentially, with each element building on the next.

1. Total purchase price (or headline purchase price): The first step is to determine what the total amount is that will be received by the seller. If the buyer knows the seller’s ask and wants to maintain a strong negotiating position, then most often the buyer sets the total purchase price equal to the seller’s ask. This signals to the seller that the buyer is willing to bridge the entire valuation gap and affords the seller the opportunity to earn the purchase price asked. However, at other times, the buyer may not be willing to bridge the entire valuation gap and will instead set the total purchase price at 70% to 80% of the seller’s ask.
2. Up-front payment: The second step is to determine what portion of the total purchase price will be paid at the transaction closing. From a buyer’s perspective, the maximum amount of the up-front payment should equal his calculation of EV and is a variable of utmost importance given it represents the buyer’s capital-at-risk — i.e., the capital in the risk zone (see Figure 4 below) that will be written off should the target underperform so significantly that its EV comes in lower than the upfront payment. Often, buyers want to further derisk the transaction by lowering the up-front payment below their calculation of enterprise value, shrinking the risk zone.

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