A Shifting M&A Environment: How To Avoid Earn-Outs

The Verit View is that, in times of growing economic uncertainty, the perceptions of would-be buyers and sellers of companies tend to diverge, and now is such a time, presenting business owners with both risk and opportunity.

An excess of capital, and the favorable benchmark of rising public company valuations, have pushed middle market acquisition multiples up. But now comes possible upheaval: higher interest rates; anti-trade sentiment in the U.S. and abroad that could dampen growth; inflationary rumblings; and the reality that the bull market is long-in-the-tooth.

Earn-outs, used to bridge the expectations of buyers and sellers, could thus become more prevalent, as acquirers seek to hedge their bets. Verit believes that business owners, through advance planning and thoughtful transaction execution, can minimize (or eliminate) the impact of an earn-out.

SRS/Acquiom, a firm that manages M&A escrows, found that from 2012 to 2015 between 12% and 19% of non-life sciences transactions involved an earn-out (life sciences deals typically are more reliant on earn-outs). The study is based on 735 private transactions with combined value of $137 billion.

How long do owners wait to get paid? About one-quarter of the earn-outs had a term of a year or less; nearly half had terms of one-to-two years; and the remainder had longer terms. And how well did buyers and sellers forecast? About half the deals, SRS/Acquiom found in a separate study, met their benchmarks.

The size of earn-outs varies widely and, given the small sample, these particular SRS/Acquiom numbers should be looked at as anecdotal. Median earn-out potential in non-life sciences deals ranged from 25% of the amount paid at closing, for 2014 deals, to a high of 53% for 2015 deals.

So, if you’re a business owner formulating an exit strategy, and you project significant growth, you should expect potential buyers to propose a sizable and potentially lengthy earn-out. You can also expect potentially difficult talks with the acquirer when earn-out payments become due.

At Verit, we work with clients long-term to combat these frustrations. To increase your chances of selling without an earn-out, manage today with a future exit in mind. That includes creating and maintaining financial statements and other records easily understood by outsiders; poor corporate housekeeping causes doubts in buyers’ minds.

What’s more, the founder or key person needs over time to make him/herself less than indispensible. That means building a senior team with a full grasp of the business, exposed to all crucial constituents, including customers. One also wants diversity of customers to make sales more reliable in a buyer’s eyes.

Choosing employee ownership as your exit strategy could help you avoid an earn-out entirely. Beginning with a partial sale, say 30% to an Employee Stock Ownership Plan, or ESOP, while continuing to run the company, you remain in control but have established a bona fide buyer who knows and trusts you. Selling the remaining stake over time – on your schedule – can in all likelihood be done without an onerous earn-out. ESOPs also offer tax treatments that can make a sale more profitable than one to private equity.

If, despite good planning, you wind up with a third-party buyer who insists on an earn-out, Verit’s standard advice includes: Be honest with yourself about the company’s prospects, even if the deal values it at the top end of your range. During the earn-out period, build a relationship with the buyer. Disputes are likelier when buyer and seller don’t know each other, SRS/Acquiom reports.

If you’re on the job, don’t let up.  Keep your team intact. These years may be crucial to your ultimate net worth. Should disputes arise, negotiate hard. Many initial claims by buyers seeking to deny earn-outs (or to assert other post-closing claims) are beaten back in negotiation or in formal dispute resolution channels.

Preparation and careful consideration of potential buyers can help you avoid earn-out headaches.