Brian Tunis
Brian Tunis is an attorney at Trenam Law who advises on M&A and private equity fundraising.

Earnouts in acquisition transactions appear to have gained popularity in response to the uncertainty created by the Covid-19 pandemic in an effort for parties to bridge valuation gaps and continue to drive transactions to close.

Per the SRS Acquiom Marketstandard database, the use of earnouts in all transactions the database tracks (excluding life sciences transactions) have increased from 16 percent of the transactions that closed in 2019 to 19 percent of the transactions which have closed in the past 18 months. As would be expected, the pandemic seems to have had an even more profound effect on smaller transactions. Twenty percent of transactions under $50 million that closed in 2019 contained an earnout and 28 percent of such transactions which have closed in the past 18 months contained an earnout. For the smallest transactions tracked, those under $25 million, the percentage of transactions containing earnouts increased even further, from 22 percent to a substantial 36 percent during those same periods.

Not only has the uncertainty surrounding the pandemic led to more earnouts, but it has led to an adjustment in the typical structure of earnouts. Earnouts have generally had post-closing periods somewhere between one and five years, with earnout periods typically heavily leaning towards the shorter end of that range. In the wake of the pandemic however, there has been an apparent increase in the post-closing earnout period with more transactions including extended earnout periods such as 2 or 3 years following the closing of the transaction. During 2019, and for the same transactions noted above, 47 percent of earnouts had a term of one year or less, 26 percent had a term between one and two years, and the remaining 27 percent had a term in excess of two years. During the past 18 months, just 30 percent of earnouts had a term of one year or less, 30 percent had a term of one to two years, and the remaining 40 percent had a term in excess of two years. Notably, there was a substantial increase in earnouts with a period of between two and three years, going from just 12 percent of the earnouts in 2019 transactions to a substantial 25 percent of the earnouts in transactions closing in the past 18 months, showing a significant shift towards three-year earnout periods.

Another aspect of the structure of earnouts, the relative size of the earnouts compared to their overall transaction consideration, has also shifted significantly towards earnouts constituting a substantially larger portion of their overall transaction consideration. Per SRS Acquiom’s 2021 M&A Deal Terms Study, the median earnout potential as a percentage of the closing payment has increased from 18 percent during 2019 to 39 percent during 2020.

Strategies for PE
Although the use of earnouts has shifted throughout the years based on market and global economic conditions, PE firms may be wise to continue to use them at an increased level for the near future. As PE firms continue to attempt to engage in acquisitions at a time when financial forecasts and valuations may be uncertain or based on financials that have been skewed by the pandemic, negotiating earnouts and more favorable structures than we have historically seen presents new opportunity for investors going forward. They should strongly consider proposing earnouts to bridge valuation gaps between the parties stemming from the pandemic to help drive transactions to close, especially for smaller transactions where the pandemic may have disproportionately affected the target company and for which earnouts are used significantly more frequently (and may be received in a more favorable manner by sellers).

A PE firm acquiring a company should also consider proposing an earnout if the firm would like to cause the parties to share the risk of sub-par future performance. For example, if the company never bounces back to its pre-pandemic condition or does not recover as quickly as projected and the earnout is not met, the parties have effectively shared the risk of such performance. This strategy reduces the cash the PE firm needs to bring to the closing, which allows it to pay a portion of the purchase price with post-closing earnings (if any earnout payment is required at all). It also keeps the seller interested in the company’s future performance by tying a substantial portion of the purchase price to post-closing performance, which aids seller retention and helps prevent seller competition.

Although earnout periods have historically leaned towards shorter earnouts, given the recent shift in the typical structure of earnouts towards longer earnout periods, PE firms should consider proposing earnouts with an earnout period of two or three years where they historically would have proposed a one- or two-year period. The longer earnout period will provide the PE firm a more accurate view into the acquired company’s post-closing economics as they are further removed from the peak of the pandemic’s impact on the company. Further, the longer earnout period can be structured in a way that will provide additional time for the acquired company to reach performance thresholds, which may benefit the seller as well by potentially giving the seller multiple opportunities to reach earnout thresholds where a slow recovery to the norm is anticipated.

Finally, given the fairly substantial increase of the median earnout potential as a percentage of the closing payment in recent transactions, it would be reasonable for a PE firm to propose an earnout which constitutes a sizeable portion of the overall consideration (with somewhere between 30-40 percent seemingly not out of line with recent transactions) as the parties seek to share the risk of post-closing performance of the acquired company. This is especially true where the PE firm is concerned about substantial risk due to an inability to get comfortable with its financial projections or where the valuation gap between the parties is significant.

Given that financial forecasts and valuations of target companies may continue to be skewed by the pandemic for the near future, PE firms should consider utilizing earnouts with terms that may vary from the terms they would have historically proposed as one of their tools to close valuation gaps, and transactions, while target companies and the economy return to normalcy.