An earn-out is a means of leaving the ultimate price that a buyer will pay for a business, in part, down to the future performance of that business. In other words, not making it only a function of your estimated Future Net Maintainable Earnings (FNME) and an industry applicable multiple. So with the rule of thumb method, we might have determined that the FNME was R10 Million, and the most appropriate multiple was, say, six — hence the value was R60 million.
In an earn-out, there are two additional factors. First, despite every assurance from the seller that future profits will evolve as shown in his FNME calculation, the buyer would prefer to derisk his purchase by asking the seller to put his money where his mouth is.
In other words, he wants some of the purchase price he is prepared to pay to be dependent on future profits earned, not just promised.
Second, despite having arrived at a reasonable estimate of his FNME, the seller might feel that this number averages out his future earnings potential rather than showing how actual profits might really accelerate in, say, years two, three or four — and which the FNME calculation will have discounted given their distance into the future.
Related: Principles in Business Valuations
The agreed solution to the buyer’s reluctance for risk and the seller’s bullish assessment of his company’s future, is to structure a deal where part of the price is paid now, and the balance is based on future performance.
An Earn-Out In Practice
Imagine a company that had net profits after tax of R6 million last year, will make R9 million this year, is predicting R12 million next year, and then R16 million the year after that.
Through a weighted average process, both buyer and seller have agreed that the likely FNME for the business is R10 million — i.e. applying most weight to the current and subsequent year, while looking back in time to check the profit history, and believing some of the future promises for profits from the forecasts provided. When structuring the deal, buyer and seller agree that they can do better through an earn-out structure.
A simple earn-out might therefore be structured by the buyer as follows:
- Current net profit before tax (R9m) x multiple (6) x 50% = R27 million
- Year 2 net profit before tax (R12m) x multiple (6) x 25% = R18 million
- Year 3 net profit before tax (R16m) x multiple (6) x 25% = R24 million
- Total consideration = R69 million
Flexibility, Penalties And Incentives
You might well ask whether receiving R69 million spread over three years is in fact any better than receiving an up-front payment of R60 million. There is little to choose between them. But this is where the flexibility of the earn-out, and its complications, now come into play.
The first change that buyers might offer, or sellers demand, is a variable multiple relative to performance. The buyer can lay down a challenge to a vendor by saying that, if you really think you can get from R9 million this year to R16 million in year three, then I will incentivise you to do so by raising the multiple from six to seven.
But, by the same token, if things do not go as well as you predict, I want to cover the risk that I have overpaid in years one and two, and hence if your year three earnings are below R12 million, the multiple falls to five.
As you can see, the permutations for adjusting the earn-out through the percentage paid up-front, the relative splits of consideration between years one, two and three, the length of the earn-out, the variations in the multiple to be applied, are legion.
And, if this was not enough, there are also the regular inclusions of caps (maximum levels the buyer will pay at each stage of the earn-out regardless of profit performance) and collars (amounts below which the consideration cannot fall regardless of how badly the seller performs) to provide upside and downside protection for each.
Other nuances might include the split between cash or shares offered as consideration (if a listed buyer) — in fact the list of variations is almost endless. And this is where the principal problem with earn-outs comes in.
Related: How Saleable Is Your Business?
Buyer And Seller Behaviour
For an earn-out to work, the seller needs to be largely left to their own devices throughout the term of the earn-out to achieve the profit targets that have been set so that they can maximise their outcome. Any interference from the buyer could be construed by the vendor as detrimentally affecting the consideration that could be earned in each year.
From the buyer’s side, this kind of vendor behaviour can be equally problematic. Armed with the knowledge that each rand NOT spent on, say, R&D or marketing actually increases the earn-out, the vendor is unlikely to make an investment in the future of a company in which he will play no part. The buyer’s inclination, therefore, is to get involved where he can to moderate such behaviour.
The only way to ensure that an earn-out can work, therefore, is for the purchase and sale agreement to have a comprehensive and detailed list of rules and regulations for both buyer and seller, with remedies and adjustments if these are breached.
It should be noted that not every action by a buyer is always detrimental to the performance of the company during its earn-out, and more often than not the buyer will provide working capital, admin support and introductions to new markets to increase sales, in an effort to grow the business for the future. So some adjustments to the earn-out are actually put in place to discount the benefits that these actions unduly bring to the seller, as the buyer does not want to be penalised by paying more for the enhancements that he has brought to the business.
Choosing The Right Deal Structure
Earn-outs are complicated beasts. Far too often buyers and sellers go wading into complex formulae with rules, incentives and penalties with the naïve belief that all can be applied seamlessly throughout, say, a three year term.
To protect their position, vendors can demand ever more complicated protections (such as the staged acquisition of their shares as opposed to a pure split of consideration) in the hopeful belief that a better structure leaves them with more power until the last payment is made.
From the buyer’s side, now that they have bought their shiny new toy, more often than not the temptation to start playing with it is just too great, and they will be frustrated that they cannot bring their own resources to bear.
On the one hand they want the vendor to behave with a longer-term future in mind, and on the other they want to enhance the performance of their purchase but not allow the seller to benefit from this.
Despite all of the complications and frustrations, earn-outs remain enduringly popular, with no two structures ever looking exactly the same.
Vendors are just too tempted by the opportunity to really cash-out when their business will be ‘flying’ in two or three years’ time to worry about the inherent complexities that may frustrate such an outcome. Buyers are keen to incentivise owners to achieve these stellar profits, and will pay for them, but at the same time are desperate to cover their downside should these targets not be achieved.
Aside from their popularity I would guess that at least 50% of all earn-outs end in tears, with the preferred remedy being a buy-out at an agreed lump sum for the balance of the earn-out, and with both parties ultimately going their separate ways.
This may not be a bad outcome for either party, but does somewhat call into question the benefits for either party of entering into such an inherently unstable deal structure in the first place.