An Earnout is a Useful Tool to Bridge a Valuation Gap

  • An earnout is an acquisition where the purchase price is partially contingent on the future performance of the target
  • Bridge a valuation gap
  • Used when possible, to measure target’s performance post-closing
  • Retention and incentive mechanism for owners/operators to stay past closing
  • Typically used in smaller deals (less than $500 million)
  • Usually tied to an accounting metric
  • Revenue, gross profit, EBITDA, EBIT, net income
  • Accounting metrics need to be able to be verified and audited
  • Earnouts are highly customized for each situation
  • Typically negotiated later in the M&A process
  • Structure can have tax and accounting implications
  • Time period can range from 1-5 years
  • Shorter time is more common (3 years and less)

Bridging the Value Gap

There are three key issues that will drive the value gap:

  • Expected operational performance of the asset
  • Valuation multiple to be applied to the operational performance
  • Buyer and/or seller requirement for a “headline” value for various relevant constituencies (i.e. limited partners, shareholders, banks, bondholders, etc.)

Two of the mechanisms that can be used to bridge value gaps are:

  1. Earn-Outs: Potential future cash or stock payments based on achieving pre-determined operating/financial targets
  2. Contingent Value Rights (CVRs): Potential future payment (usually of stock) based on stock price performance

Earn-Outs

  • The successful execution of an Earn-Out agreement requires simple and measurable criteria:
  • Careful selection of criteria and structuring of the pay-out formula
  • Agreement on accounting methodologies so neither party can manipulate base data
  • Agreement on who controls the business during the Earn-Out period
  • An arbitration system to resolve any future arguments

Advantages

  • Reduces risk of overpaying if poor operating performance post-acquisition
  • Only structure that “tests” Target Parent’s convictions of Target’s potential
  • Could help Target Parent state a higher headline value for the sale

Considerations

  • Not a common structure for public companies
  • Adds complexity to deal
  • May result in Acquirer paying for value that it creates within Target
  • Potential for manipulation in areas of management (short-term gains) and accounting
  • Potential for litigation if future value not achieved

Author: Sameer_Jain

Partner. Sameer Jain is founder of FinTech ActiveAllocator.com, the world’s first portal that seamlessly integrates traditional, illiquid and alternative investments within portfolios. Prior to this he was Chief Economist & Managing Director at AR Capital. Before that he headed Investment Content & Strategy at UBS Alternative Investments. At UBS, he served as a non-voting member of the Wealth Management Research investment committee, and as a capital allocator was responsible for all illiquid investing including fund manager selection and due diligence across the platform. Prior to UBS he headed product development & investment research at Citigroup Alternative Investments that managed over $75 billion of alternative investments across hedge funds, managed futures, private equity, credit structures, infrastructure and real estate. Here he led a team that developed proprietary models for portfolio strategy and asset allocation with alternative investments, provided investment support and research to pension plans, sovereign wealth funds, endowments as well as internal clients including Citi Private Bank. Before this he was with Cambridge Alternative Investments and SunGard (System Access) where he travelled to over 80 countries for work across Europe, Asia, Middle-East and Africa. He has written over 30 academic and practitioner articles on alternative investments with thousands of downloads at SSRN, presented at over a hundred industry conferences and has coauthored a book, Active Equity Management. Mr. Jain has multiple degrees in engineering, management, public administration and policy and is a graduate of Massachusetts Institute of Technology and Harvard University. He is a recipient of the Alfred Sloan Fellowship and subsequently was a Fellow of Public Policy and Management at the Harvard Kennedy School of Government for a year. He holds Series 7 and 66 securities licenses.

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