Navigating the Use of Earnouts in M&A Deals: Understanding the Risks and Rewards

Earnouts have been a major part of the M&A space for a long time, and they tend to be even more common when times get tougher. Earnouts give buyers some protection against an acquisition’s future underperformance, and allow sellers to enjoy a higher sales price if they can hit their projected numbers.

An earnout is an acquisition in which part of the purchase price is based on the company’s performance post-transaction. It can be thought of as a discount for the buyer if the target company underperforms, or a bonus for the company’s seller if it hits certain goals. Those goals usually center around revenue and profits, and tend to have a timeframe of two to five years after acquisition.

Earnouts help to bridge the gap between what the buyer and seller believe is a fair price for the company. They incentivize the previous owners to stay invested in the acquired company’s success, particularly if they remain part of the management structure after the transaction.

In a risk-averse environment, buyers look for a more aggressive hedge against a deal underperforming expectations. According to M&A advisory firm Foley and Larper, 2021 marked the lowest rate of earnouts in over a decade; just 20%. Unsurprisingly, it also saw some of the highest earnings multiples in public and private equity.

Foley and Larper reported an increased incidence of earnouts in their own practice this year. Earnouts are expected to be a more frequent feature in M&A deals. We also expect profitability to receive greater consideration than revenue growth, as companies prioritize earnings quality over speculative growth plays.

Approaching an Earnout can be challenging, it can frustrate a buyer if the seller won’t back its projections up by guaranteeing performance. On the other hand, a seller may feel that having part of a sales price dangled overhead shows a lack of faith in the company. However, Earnouts should serve as a bridge between the parties, helping to share a bit of the risk between them. The key is that earnout targets should be realistic, and should include a premium to compensate for the transfer of risk from the buyer to seller.

In an earnout scenario, VDR’s (Virtual Data Rooms) provide segregated access to the documents needed to report and remotely verify financial performance, or any other KPI’s that the earnout depends on. VDR’s provide secure storage, efficient access, and precise permissions for the terabytes of sensitive data that a transaction involves.

In conclusion, earnouts are a common part of the M&A landscape and they are expected to be more frequent this year. They serve as a bridge between the buyer and seller, helping to share a bit of the risk between them. The key is that earnout targets should be realistic and the VDR’s should be used to provide access to the documents needed to report and remotely verify financial performance.