Aligning the expectations of buyers and sellers is difficult during periods of economic uncertainty, and especially during the Covid-19 pandemic when business operations are being disrupted by social distancing and government-mandated closures. Due to this broader market turmoil, earnouts, which involve tying some portion of deal consideration to post-closing performance, are taking on a new level of importance in constructing M&A transactions. Contingent consideration was used last year in 27 percent of transactions in which the data are available from publicly traded buyers, according to a 2019 study by the American Bar Association (ABA). M&A practitioners are expecting that share to increase in the coming months and years, particularly in the middle market where the limited pool of comparable transactions makes valuations more challenging to begin with. Furthermore, when deal participants do use the strategy, the earnout potential as a share of overall payment is likely to grow from the ABA’s current estimation of 41 percent. In working to align value for buyers and sellers, here are four things to consider when constructing earnouts: 1. Think beyond Covid-19 The crisis will someday end, so making decisions based solely on current market conditions is short-sighted. A holistic approach accounts for business performance before, during and after the crisis. New questions to consider include: What was the seller's revenue run rate or profit margin prior to the pandemic? How many customers did they retain? And how much of their business lost in 2020 can be gained back in 2021 and beyond? Following the 2008-09 financial crisis, years of tepid economic growth and fear plagued the dealmaking landscape. Whether this recovery is faster or slower is anyone’s guess, so deal participants and their advisors must model for a variety of scenarios. It is hard to know how the next few years will unfold, making earnouts all the more appealing. 2. Quantify and contextualize Today’s disagreement over valuation can become tomorrow’s legal dispute, and much of the earnout-related headaches originate from ambiguity. Quantifying and contextualizing starts with selecting the appropriate metric(s) to measure long-term success. The most popular thresholds, according to the SRS Acquiom MarketStandard database, are based on: ● Revenue: 65%
● Earnings: 17%
● Regulatory Milestone: 2%
● Other: 33% Earnouts are often binary, such as with the yes or no outcome of a regulatory approval process or acquisition of a major client. Regardless of the metric used to construct earnouts, its definition should be as specific as possible. For example, if profit is the measuring stick, then how will general and administrative expenses be handled? This attention to detail takes on a new level of importance when contextualizing for Covid-19. Deal parties need to discuss, for instance, how Payroll Protection Program loans will be handled. The timeline is another crucial element. How will earnout metrics be affected if the crisis drags on another six, 12 or 18 months? Extending the timeline can alleviate near-term market volatility. In addition to contextualizing the structure of earnouts, deal participants must have a clear strategy for the process by which those milestones are achieved. This includes establishing covenants around the amount of control a seller will have post-closing, as well as the level of involvement of their current management team. M&A practitioners and their clients should discuss what happens if things do not go as planned. Prepare for a potential dispute by deciding ahead of time how it would be resolved, and even by selecting who would serve as an independent arbitrator. 3. Be flexible Earnouts do not have to be all or nothing. Put a floor and cap in place to cope with the unpredictability caused by Covid-19. And consider pro-rata payments or catch-up payments to account for stronger performance over the back portion of the earnout structure. The aftershocks of Covid-19 could impact businesses for years to come, making all-or-nothing earnouts a riskier proposition for sellers who have no way of knowing when normal operations will resume. 4. Weigh alternatives Earnouts are a helpful risk-allocation mechanism in structuring deals during the Covid-19 crisis, but they are far from the only one. Employee-based compensation provides the seller’s ownership with a vested interest in the longer-term success of the company—without relying on the whims of the coronavirus and the broader economy. Post-closing purchase price adjustments allow parties to square up net working capital figures and other estimations that were made at the time of closing. And at a time when many buyers are strapped for cash, using stock as consideration serves to enhance liquidity while providing sellers with upside potential in the combined business. Conclusion It is a difficult time for many middle-market owners. Businesses that were booming to start the year have been hammered by a once-in-a-lifetime pandemic. With no end to the crisis in sight, M&A practitioners are hearing from prospective sellers who cringe at the thought of another multi-year rebuild like the one that followed the financial crisis. At the same time, private equity firms, family offices and business owners who are relatively unharmed are going on the offensive to find deals. Future performance is harder than ever to predict, leading deal participants to work through divergent views about valuation and upfront purchase price. Earnouts, when constructed thoughtfully, are a great way to align longer-term interests when the economic and company outlook is murky.
